1. Morgan Crucible (LSE: MGCR), rated a BUY by Evolution Securities
Overseas buyers have been snapping up niche UK engineers to exploit their technological expertise. Last week was the turn of Hamworthy, a supplier of equipment for LNG cargo ships. It was acquired by Wrtsil, a Finnish maker of marine propulsion systems. Seven days earlier British engineer Charter International was bought by US giant Colfax. I think the next target will be Morgan Crucible, a global player in ceramics and advanced materials.
Compared to its peers, Morgan is relatively underweight in emerging markets. Yet they delivered top-line growth of 35% in the first-half of the year. This was down to powerful domestic demand and the ongoing relocation of Western customers as production migrates to low-cost countries. The latter, a type of piggy-back strategy, only works if you have top-flight technology that can't be easily copied. Morgan has this in spades. Examples include electrical brushes used in rail traction applications, lightweight body armour for soldiers and military vehicles, and ceramic cores for turbine blades.
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At the half-year, revenues jumped 11.8%, with underlying pre-tax profits surging 66% as the benefits from the firm's operating leverage (high fixed costs compared to variable ones) and cost-cutting measures kicked in. Better still, its products have demonstrated that they enjoy robust pricing power. Even during the last recession Morgan managed to push through 2% price increases to protect earnings from higher raw-material costs. Now it enjoys earnings before interest, tax, depreciation and amortisation (EBITDA) margins of 12.8%, up from 8.2% in 2009.
The deteriorating macro conditions haven't knocked it off its stride either. "Performance remains in line with the board's expectations", with the "ratio of net borrowings (£244.3m in June) to EBITDA set to fall below 1.3 by December" from 1.5 in June. Looking ahead, Morgan is on track to hit its stretching, yet achievable, financial goals. These include doubling pre-tax profits from £75.7m in 2010 to nearer £150m by 2013 and boosting return on capital employed (defined on page 52) to 35%.
With this in mind, the City is forecasting 2011 turnover and underlying earings per share (EPS) of £1.1bn and 27.4p respectively, together with a 9.2p dividend (or 3.8% yield). I rate the stock on a ten-times through-cycle EBITA. Adjusting for its debt and a £91m pension deficit, that generates an intrinsic worth of 350p a share. In the event of a bid, this could spike to north of 450p.
In the short term, volumes in Morgan's hard disk drive unit could be hit by recent flooding in Thailand. There are also the usual concerns of economic wobbles and foreign-exchange fluctuations to consider. Nonetheless, this is a firm to tuck away for the long term. Investment bank Evolution has a 370p price target. Full-year results are due out on 15 February.
Rating: BUY at 270p
2. Elementis (LSE: ELM), rated a BUY by Altium Capital
The bulk chemicals industry is notoriously cyclical and characterised by high volume, wafer-thin margins and belligerent competition. But life is very different for the sector specialists. Earnings at niche producer Elementis are much healthier and far less volatile than they might be owing to its clever product differentiation. This was clear in the firm's October announcement, when it reported that it was on track to hit its 2011 targets, with all three divisions trading ahead of last year.
The biggest of these, Elementis specialties, generates 68% of profits. The division's chemicals are used in paints, inks, adhesives, moisturisers, handcreams and mascara. They greatly improve the feel, viscosity and flow of these products because they include hectorite, a rare substance that gives Elementis's offerings a key competitive advantage. Indeed, Elementis owns the world's only commercial-grade hectorite clay mine (with a life expectancy of 50 years). Consequently, this division is a major bread-winner, with first-half operating margins (EBITA) of 20.8%.
Most recently, though, the stand-out performer has been high-grade lubricants sold to oilfield service businesses. These are used to dissipate heat at well-heads and make it easier for drillers to remove underground debris from bore holes. Here, volumes rocketed 48% in the third quarter, driven by the continued frenzy in shale-gas exploration in North America. Further expansion at the firm's Charleston facility is planned, as shale gas fracking' requires up to ten times more of these additives than standard vertical drilling.
Third-quarter sales at its chromium unit (28% of profits) rose 8%, with all factories at full steam. Its site in North Carolina is the only substantial plant left in the country supplying the chrome-based coatings used in some car parts and to treat leathers and timber. The firm's smallest division is bulk surfactants. Its products go into household detergents and industrial cleaners. This operation is still profitable largely because it is co-located at another group facility in Holland. The plan is gradually to shift capacity away from this towards higher-value specialties.
Analysts expect 2011 turnover and underlying earnings per share (EPS) of $775m and 20.3 cents respectively, rising to $820m and 22.6 cents in 2012. That puts the shares on a p/e ratio of less than 12, with a 2% yield. I would rate the group on a ten-times EBITA multiple. After adjusting for the $57m pension deficit, that delivers a value of 175p a share.
Elementis is exposed to environmental spills, supply chain disruption, tightening legislation and foreign-exchange fluctuations. But it has coped with these in the past, and should be able to do the same going forward. Investment bank Altium Capital has a target price of 180p.
Rating: BUY at 151p
Paul Hill also writes a weekly share-tipping newsletter, Precision Guided Investments. Seewww.moneyweek.com/PGI, or phone 020-7633 3634.
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Paul gained a degree in electrical engineering and went on to qualify as a chartered management accountant. He has extensive corporate finance and investment experience and is a member of the Securities Institute.
Over the past 16 years Paul has held top-level financial management and M&A roles for blue-chip companies such as O2, GKN and Unilever. He is now director of his own capital investment and consultancy firm, PMH Capital Limited.
Paul is an expert at analysing companies in new, fast-growing markets, and is an extremely shrewd stock-picker.
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