With in-trays empty and customers' warehouses full after a summer lull, orders dried up and profit warnings book-ended the engineering sector's third-quarter reporting season. A speedy recovery looks highly unlikely and further casualties are a near certainty. But turning one's back on a sector with such global reach is not the answer, so investors need to know which stocks to stick with as well as those to avoid.
"The only clarity is that there is not any," said Investec Securities analyst Chris Dyett as the rush of updates drew to an end. That's a sentiment echoed by Jon Lienard at rival N+1 Singer. "Generally, destocking meant most of the industrials had a very bad September and no one is really sure what happens next," he says.
"Much of it is guesswork at the moment, so most companies were reluctant to provide an outlook for 2013. Those that did like Melrose got smashed for it," added Mr Lienard. But the City remains divided. Forecasts for the rest of 2012 look fine given the fact that companies have just tweaked expectations, but forecasts for next year are all over the place.
We probably won't get any further clues, certainly from the engineers with a December year-end, until the middle of February. Melrose could lie low for longer. That means no guidance on 2013 for at least three months. In the meantime, there will be a lot of fingers in the air and share prices will be very much sentiment driven.
Panmure Gordon's Oliver Wynne-James is pessimistic. He's downgraded his stance on the sector from positive to neutral and warns that lower order intake means the fourth quarter will be even worse than the third. "Supply chains and production schedules should take more than a quarter to adjust to the recent step-change in end-markets. We expect casualties to occur well into 2013," he said.
Clearly, there are a number of problems. Europe is still the UK's largest export market and last year almost half of all exports ended up there. The region staggers from one disaster to the next and both the economic and political intractability of the situation make progress painfully slow. China is coming off the boil, too, and the US fiscal cliff is approaching fast.
Nerves over numbers
It's difficult for companies to make investment decisions given all this uncertainty, and many are sitting on their hands because of the obvious potential for something to go badly wrong. True, the massive impact of destocking in 2009 is unlikely to be repeated - supply chains are leaner now and there's less stock around - but there's still the potential for a shock.
A glance at the data is telling. Output in the eurozone fell sharply again in November, according to the latest purchasing managers' survey (PMI). The eurozone economy is "entrenched in the steepest downturn since mid-2009", says Markit's chief economist Chris Williamson, who also warns that "the downturn is set to gather pace significantly in the fourth quarter".
The European Commission has just slashed forecasts for eurozone GDP growth in 2013 to 0.1 per cent, and in the UK the CBI says production is falling and order books are flat. A recovery in the US looks fragile, too - its manufacturing PMI for October came in at a 37-month low. Much, then, depends on China.
There, the manufacturing sector grew for the first time in over a year in November, which makes a soft landing look more achievable. The new Communist party leadership will be keen to make its mark and may sanction another slug of stimulus just to make sure. Morgan Crucible, which makes parts for blast furnaces and solar panels, will hope so after weak industrial demand ruined its third quarter.
Fine China
A sharp decline in orders for pipes and valves used in steel production forced a profit warning out of Cookson, too, and one of its two Chinese plants churning out crucibles for casting solar cells is being shut down. But greater factory automation means precision instruments maker Spectris is growing fast in Asia. So too are Renishaw and Rotork.
That geographical bias is proving the difference, with engineers struggling to grow at all in Europe, and North America is little better. There's also a growing divergence in performance across end-markets, and solid long-term growth stories are becoming increasingly important. Rotork, Renishaw, Halma and Spirax-Sarco stand out and have proven themselves in the past. These defensive names with above-average organic revenue growth and higher margins outperformed the sector by 25 per cent between July 2008 and July 2009, according to Credit Suisse. And they're doing it again.
It's for this reason we're moving Spirax-Sarco to a hold from a trading sell rating. The steam and pump engineer has returned to growth after a poor first half and underlying demand is there. We like Rotork, too, given the oil and gas industry loves its valves and control systems; only a lofty valuation of 21 times earnings stops us recommending it as a buy. Valuation is an issue at precision engineer Renishaw, too, and at Halma, where Chinese health and safety legislation will make a valuable contribution to earnings for years.
What now?
"It looks like there will be more downgrades than upgrades next year," predicts Arden Partners analyst David Larkam. Mr Wynne-James agrees: "We've cut our expectations for organic growth in 2013 from 4 per cent to zero, but still think there are a few more downgrades to come. We're not predicting a global slump, but the trough in Europe is deeper than expected."
Certainly, the market isn't pricing in a US downturn, but that's just what many think is on the cards. Industrial giants such as Caterpillar and Cummins have warned of dwindling demand and the widely watched Chicago PMI reflects further contraction, new orders stuck near neutral and shrinking order backlogs. There's anecdotal evidence that investment has stopped, too.
Companies will also keep running down inventories into the new year, but getting an accurate hook on stockpiles is difficult. Few companies are really sure what's in the pipeline, so it requires a lot of guesswork. And customers are wary of placing large orders. Instead, they're buying less but more frequently, and at the last minute, too, so visibility is shorter than usual.
Even once destocking has washed through the system, manufacturers will have to adjust to what ever underlying growth levels prevail in the market next year. In this fiscal cliff environment, however, there isn't much to be found. What's more, comparisons become "horrendous" in the first half of 2013 making year-on-year growth unlikely. Indeed, Mr Wynne-James says we should prepare for a "mild" six-month long industrial recession in the US from April.
| FAVOURITES: |
| Aerospace engineer Senior makes airducts, tail-fin parts and engine casings for Boeing and Airbus. They're sitting on a seven-year backlog of orders for thousands of new fuel-efficient planes, and build rates are accelerating. Less cyclical aerospace work accounts for more than two-thirds of the business and exceptional visibility deserves greater reward. We're sticking with GKN, too. Despite weak automotive markets, buying Volvo Aerospace was smart and still isn't fully factored into the valuation. |
| OUTSIDERS: |
| Cookson and Morgan Crucible stand out as outsiders. We've downgraded both from buy to hold and will not return until the fog clears. Cookson may grab some headlines when it splits in two on 19 December, particularly Alent, the renamed performance materials division. Still, it has problems of its own and we'll watch from the sidelines. Highly-cyclical engineers desperate for growth could be tempted to start discounting. Morgan Crucible looks like a possible candidate and, priced at over 10 times earnings, the shares aren't cheap, either. |
Jon Lienard, analyst at N+1 Singer
Recent updates from the industrial sector have been consistent in that they have offered little visibility. Several companies chose not to talk about the 2013 outlook (e.g. IMI, Bodycote), whereas others did (or had to), to the detriment of the share price, such as Melrose and Cookson. The lack of forward guidance is understandable given worldwide uncertainty – the US, which has been holding up well, is now slowing ahead of the fiscal cliff, there is some hope that China has bottomed but we await policy clarity from the new Congress, and then there’s Europe, which remains depressed.
Given the uncertainty, we prefer to look at stocks with secular growth stories or self help programmes. Senior (Buy, 233p PT) has seen a subdued share price for the past six months due to comment on some of its more peripheral areas (Automotive, Heavy Truck, Defence); we feel that this fails to recognise the value of the ‘guaranteed’ commercial aerospace growth and doesn’t reflect the relatively stable mix of non-aerospace business.
Fenner (Buy 408p PT) has experienced a volatile year with sentiment being driven by US coal industry woes, caused by the shale gas boom. In conveyor belting, Fenner has significantly moved up the value chain in recent years to become much more than simply a manufacturer of belts and we see strong long term potential from ongoing global coal usage. There are short term uncertainties though, a cold winter in the US would help to get coal and gas usage back into balance, another mild winter would be bad news.
Trifast (Buy, 60p PT) remains modestly valued, but is reporting good profit growth as continued new business wins and leverage of its low cost, high quality and high margin Malaysian acquisition outweigh the weak economic backdrop.
