British Engineering – A Creature of the Past?

British engineering has had an illustrious past – from Newcomen, Watt and Savery's development of the steam engine in the early 18th century to Fleming's invention in 1904 of the vacuum diode, British engineering and ingenuity has formed the foundations for much of the modern world.

Of late, however, the going has been much tougher. British engineering is certainly not the force that it once was. After the second-world war, almost half the workers in Britain were employed by the engineering and manufacturing industries. Today less than 15% of the UK workforce makes a living from the sectors.

Engineering has developed a reputation in the media for being “dirty, greasy metal-bashing”, with information technology and the services sector being seen as the sexy places to be. Inventor, James Dyson gave a speech called “Engineering the Difference” in 2006 bemoaning the lack of interest in engineering amongst the young. "We produce 24,000 a year. Compare that with the 350,000 in China and the 450,000 in India… In 2005, the UK produced 77,000 media and social studies graduates”. [ref] “Engineering the Difference", http://news.bbc.co.uk/2/shared/bsp/hi/pdfs/dyson_10_12_04.pdf [/ref]

The emergence of China and India as major manufacturing bases has inevitably lead to questions about the competitive strength or even viability of much of British engineering.  On top of this, the sector, as with nearly all others, has suffered over the past 24 months dominated by the near collapse of many of the world’s biggest banks. The essential remedies for this, recapitalisation, deleveraging and a ‘back to basics’ approach to bank lending, inevitably resulted in a collapse in demand across is end-user markets.

Don’t believe the hype

While the long term trend of increased global competition is indisputable, there are a number of reasons to think that both the short and medium outlook for British manufacturing is not as dire as is widely believed. As Philip Whyte of the Times has noted, until the credit crunch hit global output, manufacturing output in the UK was higher than it had ever been. "In 2007 it was two and a half times higher in real terms than it was in 1950. And despite the surge in imports from China, production was 7.1% higher in 2007 than it was in 1995". [ref] Times Article, http://www.timesonline.co.uk/tol/comment/columnists/guest_contributors/article5897706.ece [/ref]

After years of strong growth, increased fuel costs, material costs and wage inflation are causing Far East manufacturers to raise their prices and the cost gap with UK manufacturing has been closing for sometime. There are also many well-documented stories of inadequate quality control relating to low-cost offshore production. 

In terms of underlying demand, company de-stocking and personal non-replacement of depreciating assets have limited shelf lives and, barring Armageddon, normal activity has to resume, i.e. cars fall apart or become prohibitively costly to keep on the road, aircraft become unserviceable, new steel for construction becomes impossible to source and so on.

In addition, two UK government initiatives in the past twelve months have been of considerable help to the sector:

1)     £2.3bn in loan guarantees to the UK car industry announced in January 2009. In return for undertaking to develop low carbon vehicles and generally updating their business models this basically gave the industry confidence to move forward without constantly looking over their shoulders to satisfy banking covenants and lenders ever stricter criteria. There will probably be no cost to the UK taxpayer as increased demand has lead to positive cash flows enabling the company’s loans to be repaid in normal course. There is also the ecological long term benefit of low carbon vehicle developments.

2)      UK Car Scrappage Scheme announced in late April 2009, to widespread scepticism from economists and business journalists, has proved a resounding success in re-stimulating demand for new cars with over 150,000 new vehicles purchased with the assistance of this allowance in the first three months.  Again the cost to the UK taxpayer is virtually nil with the £1000 government funded rebate covered by VAT receipts which would not have been there if the sale had not happened. Again the environmental benefit is ‘in for nothing’ with ten year old vehicles being replaced on the road by much more fuel efficiency.

Recovery Underway?

For the UK based automotive industry (Toyota, Nissan, Honda, Ford and others), economic recovery appears to be well underway with the UK aerospace sector  (the largest in the world after USA) also now increasing in activity. The largest engineering and aerospace economies are in the U.S.A and there also, it looks like the corner has been turned; GDP now rising after a year of decline (U.S. Commerce Department) and retail sales rising after a similar period of decline (Moodys). True that unemployment still stands at 7.5% (U.S.Bureau of Labour Statistics) but from where we’ve been and still in the relatively early stages of economic recovery that is expected.  Employment is always the last piece of the economy to benefit.

The media always expect instant solutions and large economies cannot work like that. There is little doubt that, given more time and especially under its new leadership,  America will lead the world out of recession. It is in fact well under way and the markets have recognised this with Dow Jones Industrial Index up 50% in the last six months far outstripping FT100 which is up about half of that.

How to play the Sector

For those interested in investing in engineering, there are a number of attractive listed players on the London market:

• Weir Group manufacture pumps, turbines and valves  and have a market capitalisation £1.3bn,  annual turnover (year to December 2009) forecast at £1350m and pretax profits £160m.  50% of turnover is in the highly profitable and resilient are of aftermarket  sales of spares and services. Good overall growth is coming from South American, Asian and African markets.
• GKN manufactures drive shafts and axle joints and core markets are automotive (75% of sales) and aerospace.  The group halved its debt with a recent  rights issue which successfully raised £423m is in good shape to benefit from the now commenced upturn in these markets. Market capitalisation is £1.7 bn, annual turnover (year to December 2008) £2060m and pretax profit, after adjusting for restructuring and other one off costs, of £140m, dominant player with 48,000 employees worldwide in 30 countries.
• Smiths Group manufacturing aircraft components and surveillance equipment for the military  this group of companies straddles the engineering and defence sectors . Market capitalisation is £3.1bn and for the year to July 2009 turnover is forecast to be £2653m and pretax profit £280m. Overall margins are down from the year to July 2008 but no more than is to be expected. With gearing at 1:1 with shareholders funds not as strongly financed as other players.
• Cookson Group is a company which has come through severe financial pressure during the past twelve months – the combined effects of the recession and the cost of acquiring a major competitor  (FOSECO) in its very important ceramics division. The pressure was eased by the £240m proceeds of a rights issue in early 2009.  In addition to ceramics (supplies to the steel industry for handling molten metals) the Group also has significant electronics and precious metals business. Market capitalisation is £1bn, for the year to December 2009 turnover is forecast at £1964m and pre tax profit at a nominal £21.4m which over the next two years  is expected to recover to its 2007 level of £150m. It has 15,000 employees in over 40 countries.

With secure markets, growth potential and safely financed the safe way to play the sector may be Weir Group with a solid 3% yield on investment in their ordinary shares at 654p. For potential capital growth, one choice is GKNwho, whilst at this time have still to emerge from the pain of a large restructuring exercise, will hopefully return to the dividend lists within the next twelve months. GKN were always fairly generous with dividends – 9p per share in 2007. Over the next twelve months, GKN shares could double from their present level of 111p.

Smaller Engineering Sector companies that may be worth a look are machine tools specialist 600 Group – a recovery play but very cheap at 16p per share and can makers Rexam who continue to pay a generous dividend, the shares yielding 8% at their present level of 269p and with plenty of potential for that to appreciate.

There’s Life in the Old Dog Yet

Despite the doom and gloom you read in the British media, there's ground for continuing to believe in the British Engineering sector. Clearly, the global market for engineering products has become much more competitive and will continue to do so. As a result, many old-school British manufacturers with strong brands but outdated machines and an inflexible workforce have unfortunately gone to the wall. However, this is not to say that it’s not possible to invest in flexible and forward thinking British players who are able to compete globally. As Richard Blackburn, Managing Director of Energi, noted in a recent Businessweekly article - "From what we see is that UK engineering took a real bashing during the 80's and 90's and those that have survived are made of pretty tough stuff. Moreover, these companies are run by very capable businessmen, businessmen that have survived and grown their businesses with minimal support from the Government or EU coffers”. [ref] Business Weekly 2008 article, http://www.businessweekly.co.uk/2008110632730/acro-precision-technology/engineering-sector-remains-buoyant-despite-economic-concerns.html [/ref] British engineering has had an enormously important past but investors in it should hopefully also enjoy a bright future...