Piggy in the middle shows its mettle

Smaller Companies
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The Independent Online
IN AN era dominated by silicon and plastic, steel is not a material to set the imagination soaring. British Steel languishes on a far-below- average price/earnings ratio of 4.7. But steel does not have to be a dirty word for investors. Shares in steel fabricator Severfield-Reeve have soared to 175p since I recommended the shares at 100p last September. They are still benefiting from new order announcements and analysts have moved profit forecasts higher.

Not on quite such a rocket-powered profits ascent but looking promising is Precoat International, at 164p, a recently floated group which has become the UK market leader in the stocking, distribution and processing of precoated steel. Its traditional construction markets may be languishing but the group is doing well from converting manufacturers of white and brown goods such as washing machines, microwave ovens and videos to the advantages of using precoated metals.

Precoat stands between producers of long runs such as British Steel and its customers who typically want small runs in specialised sizes. The steel giants run steel through their coating plants to produce huge 10- ton reels of coated steel. Precoat runs the reels through its equally automated plant to slit and cut it to size, straighten it and possibly pierce holes in it. The customer then calls it off on a just-in-time basis to supply its own automated assembly lines.

At first you might think that Precoat could become redundant in this process and vulnerable to having its margins squeezed. The truth is almost exactly the opposite. Both British Steel and some of Precoat's big customers such as Hoover often find themselves struggling to make profits. The former needs Precoat's ability to handle small quantities and develop new applications and customers to help it sell its value-added material. Hoover and others need Precoat to solve their stocking and quality control problems and give them the ability to automate their factories and cut manpower. Precoat, seemingly the piggy in the middle, is the one that makes most of the money.

This can be seen in the group's excellent growth record. Since 1981, briefly interrupted by the early 1990s recession, sales have grown from around pounds 2.5m to nearly pounds 40m. The profits record since 1992 runs pounds 1m, pounds 1.3m, pounds 1.8m and pounds 2.5m for the year ended 30 April 1995. Subsequent half-year figures to end October 1995 showed profits rising by 24.5 per cent to pounds 1.6m on sales ahead 20 per cent to pounds 23.1m. Earnings per share were up by 19.1 per cent despite the issued share capital being increased by the flotation.

Years of strong growth have made Precoat the UK market leader with a 40 per cent share. Uniquely among UK service centres for the distribution of precoated steel it is the only one not tied to one supplier. Nevertheless it has an excellent relationship with British Steel, still its main supplier.

The outlook is for further strong growth. Firstly the business would benefit from a stronger economy. The struggling construction sector still takes 30 per cent of output and chairman, Ian Williams, concedes that demand is patchy in some traditional markets. But he says the group is able to offset this patchiness by finding new applications, particularly in the durable goods area.

For example Panasonic is ramping up production of microwave ovens in its Welsh factory, which increases its need for precoated steel from Precoat's main service centre in Newport, South Wales.

Most excitingly for investors, 1997-98 is shaping up as a potential cracker of a year. Williams says the group should be able to grow earnings at 15- 20 per cent in a normal year. Vintage years come when on top of that a major factory converts from old fashioned welding and painting to the precoat process. Lec Refrigeration is expected to make just such a conversion in 1997 with sourcing from Precoat. The timing looks perfect because the group has spent the bulk of the pounds 2m raised by last year's flotation installing a state-of-the-art slitting line at Newport which will treble capacity.

Analysts are forecasting Precoat group profits reaching pounds 3m for the year to 30 April 1996 and pounds 3.5m for the following year to drop the p/e to 12 and then 10.4 with a dividend yield around 4.5 per cent. That looks excellent value and takes no account of the prospect of a significant acceleration of the growth rate in 1997 perhaps to 30 per cent plus. The shares have already performed well since flotation but the best should be still to come.