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FTSE 350: Sterling's loss is engineering's gain

The outlook for the engineering and industrials segment is broadly favourable, though several factors we thought would influence events in 2017 are yet to play out
January 25, 2018

As November pulled to a close, GKN (GKN) reversed its decision to appoint Kevin Cummings as chief executive. At issue was the group’s North American aerospace division – headed by Mr Cummings – which had overestimated programme inventory and receivables by between £80m and £130m, incurring a non-cash write-down in the process.

GKN’s increased provisions were timely, coming just over a month before the arrival of ASC 606, IFRS 15 and IFRS 9. These accounting and reporting edicts – which will no doubt have occupied many engineering and industrials companies – cover areas such as revenue recognition, along with how companies classify and measure financialassets and liabilities. The standards’ introduction applies to every sector, although due to the nature of their billing arrangements, some companies will be forced to take a closer look at their existing classification criteria. GKN won’t be alone.

Accounting effects aside, the FTSE 350 constituents within the wider engineering and industrials segment may feel a sense of déjà vu as they move into 2018. Some of the main factors we thought would influence the performance over the past 12 months have yet to fully play out.

The example of Weir (WEIR) provides a case in point. The share price of the Glasgow-based valve and pump manufacturer doubled through 2016 (albeit from a low base) after energy prices had stabilised, but gains were relatively modest in 2017 despite positive earnings catalysts in the shape of increased fleet utilisation in North America’s unconventional oilfields and tightening industry capacity. The retracement in energy capital budgets is analogous to the turning circle of an oil super-tanker – so investors may require a degree of stoicism.

We were also confident that the wider sector would derive material benefit from President Trump’s pledges on tax cuts and infrastructure spending. As we know, Congress has only made good on one-half of that equation, although you would be hard pressed to find a US politico who doesn’t recognise the imperative for a major infrastructure overhaul in the Land of the Free. Nonetheless, there are already signs that the proposed reduction in the US corporate tax rate from 35 to 21 per cent could drive aggregate demand in the economy, but we await congressional approval on the infrastructure budget.

Exposure to the US stimulus programmes forms only part of the narrative. As you’ll read elsewhere in this review, the issue of the UK’s departure from the single market and customs union could have material implications for exporters and manufacturers, but we have no more clarity on the issue than we did a year ago – everything is still largely conjecture. However, what’s undeniable is that we’ve witnessed a steady improvement in the UK manufacturing sector following the EU referendum and the consequent devaluation of sterling.

The latest trends survey published by the Confederation of British Industry (CBI) shows that the UK manufacturing industry has kept order book levels near a 30-year high due to strong demand for motor vehicles and transport equipment. Given the automotive sector is in cyclical downtrend, that’s slightly surprising. The survey found that 42 per cent of manufacturers increased output in the final quarter of 2017, against just 11 per cent that reported a negative trend. The manufacturing sector, ergo engineering and industrials stocks, are being helped along by the resurgent eurozone economies, as evidenced by export order books, which remain at their highest levels since the mid-1990s.

Industry groups have warned that our departure from the European Union could exacerbate the UK’s skills shortage; there have been numerous anecdotal accounts of staff from other European Union countries choosing to move elsewhere due to the devaluation of sterling. With enhanced euro earnings in, say, Germany – it suddenly becomes a less attractive proposition to work in the UK. Never fear, the government has deemed 2018 the ‘Year of Engineering’, in a bid to encourage more young people to pursue careers in the engineering industry. A worthy enough aim, but the FTSE 350 engineers would probably derive more near-term benefit from clarity on how easily they’ll be able to tap the continent’s labour markets post-Brexit.

Company Price(p)Market value (£m)PE RatioYield (%) 1-year change (%)Last IC view
Bodycote9971,90827.21.658.2Hold, 888p, 27 Jul 2017
Coats Group811,15016.61.241.6Hold, 79.2p, 01 Aug 2017
Fenner47692426.90.959.8Hold, 357p, 20 Jul 2017
GKN4487,68731.72.032.2Hold, 443p, 16 Jan 2018
Hill & Smith1,3131,03319.92.111.7Hold, 1,383p, 11 Aug 2017
IMI1,4093,83323.62.831.7Hold, 1,214p, 31 Jul 2017
Rotork3032,63430.31.716.1Hold, 242p, 09 Aug 2017
Smiths Group1,6856,66836.92.613.1Buy, 1,518p, 25 Sep 2017
Spirax-Sarco5,7604,23733.61.435.5Hold, 5,730p, 09 Aug 2017
Vesuvius6171,67329.22.745.0Buy, 583p, 05 Oct 2017
Weir Group2,1904,91035.82.09.2Hold, 1,871p, 27 Jul 2017