Shares in British engineering companies rocketed last year. That was thanks to buoyant demand in Asia, a resurgent car industry and higher exports on the back of the weaker pound. Spectris, Britain's biggest maker of production-testing gear, was no exception its stock soared three-fold from 2009 lows.
The bulls justify this jaw-dropping climb by pointing to the firm's cracking trading update on 15 January. Here, Spectris reported a 12% jump in like-for-like turnover, adding that 2010 sales and adjusted EBITA would come in at £905m and £140m respectively. In particular, the 'Test and Measurement' division stood out during November and December, contributing "substantially" to the improvement.
Don't get me wrong this is a terrific achievement, and I like Spectris as a business. Nonetheless, regardless of the gangbuster numbers, the shares have run too hard too quickly, and now trade above most sensible valuation metrics. And let's not fool ourselves, this is a 'feast and famine' industry. And right now, that matters.
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For starters, around 70% of revenues are related to capital expenditure only 30% are derived from recurring income sources, such as repairs and maintenance. Additionally, many of Spectris's customers operate in the cyclical mining, automotive, machining and paper-making industries. And at the height of the 2009 recession, Spectris's profits were hammered. That forced it to make redundancies and ask the remaining staff to forgo bonuses and take unpaid leave.
Spectris (LSE: SXS), rated a BUY by Panmure Gordon
Odds are, if there is another meltdown, especially in Asia, we'll see a repeat performance. Worst still, with raw-material costs rising and greater price competition expected, Spectris's operating profit margins of more than 15% could also become squeezed. I suspect a fair chunk of recent growth has occurred simply because of inventory rebuild, or a catch-up in deferred orders. If I am right, then this temporary boost to volumes and margins will settle down once client requirements get back on an even keel.
The valuation doesn't help either. The shares trade on a stretched price to earnings (p/e) ratio of 15.6, and pay only a 2.1% yield. I would value the group on a ten-times through cycle EBITA multiple (assuming margins of 13%). After adjusting for the £18.5m pension deficit and £105m of net debt, that generates an intrinsic worth of around 910p per share.
True, Spectris could be snapped up by a larger rival (such as Siemens) that wishes to leverage its niche products across a much wider area. However, with the shares already priced to perfection, I think any takeover is unlikely. So, with full-year results due out on 25 February, I would advise shareholders to bank profits.
Recommendation: TAKE PROFITS at 1,354p
Paul Hill also writes a weekly share-tipping newsletter, Precision Guided Investments
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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