Things are looking up for beleaguered engineers

ARE WE starting to see the glimmer of an investment opportunity in Britain's beleaguered engineering sector? The engineers have had a torrid time of late, hit by the combination of a global economic slowdown, a strong pound and the evaporation of pricing power.

Over the last year the general engineering sector has under-performed the rest of the market by 23 per cent. Last year was scarred by a raft of profits warnings and downgrades as metal-bashers became one of the stock market's great untouchables.

Things have started to run, however. Since the dark days of early October, when the whole market bottomed out, there has been a gradual improvement.

The sector's full year results season - nearly all the general engineers reported in March - was completed with barely a hiccup. There was one profits warning relating to a non-trading issue at Morgan Crucible but other companies came through unscathed. This has facilitated the start of a re-rating, and engineering analysts are beginning to make encouraging noises about prospects.

"Now we have got through the results season it is clear that the worst fears of the market have not been realised," says Guy Hewitt at Charterhouse Tilney. "Companies have shown that they can be more resilient in difficult markets."

Though markets are still difficult and the outlook is mixed, Mr Hewitt is positive on the sector.

"The next movement should be upwards," he says, "though we may have to wait for the outlook statements with the interim results before we know for sure. But the sector is definitely under-valued."

Paul Compton at Merrill Lynch agrees, saying the sector "should start to outperform" and that the risks are now far lower than in November, when stock markets still looked vulnerable and demand uncertain.

History is certainly on the sector's side. According to Charterhouse Tilney, this cyclical sector is now at the same level relative to the All Share index as it was at the bottom of the last cycle in 1993. The broker says there is currently limited share price downside.

There are several reasons for this. First, the economic outlook is much better than it was back in November. The prospect of outright recession looks limited and engineers are proving resilient in markets that are still tough.

Second, interest rates are coming down, which should support demand, particularly in key markets such as the UK and the US.

The strength of sterling continues to be a factor for engineers but at current levels company profitability should not be hit by another wave of exchange rate costs.

Another boost is corporate activity, which has been gathering pace, with deals including TRW-LucasVarity going through and others, such as an FKI buyout, being rumoured.

Problems remain, however. The lack of price inflation is putting pressure on margins and this is expected to continue. Supply-side pressures will also remain as demand continues to be precarious. The companies that will be able to defend prices and volumes best are those with strong market shares and unique products. Pressure will be greatest at the commodity end of the market.

Which companies look the best bets? McKechnie, which impressed with results earlier this week, is favoured. It has strong market shares and is not overly exposed to the troubled automotive sector. It is improving margins and has the firepower to fund pounds 200m of acquisitions.

Bodycote International, the metals testing and materials processing group, is another rated a buy by analysts, supported by good growth prospects and continued acquisitions.

Analysts also like the look of FKI, the materials handling, electrical equipment and windows group.

Elsewhere, the jury is still out on Tomkins, which is struggling to shake off its diversified industrials tag despite being reclassified as an engineer.

Though yield support is strong, the company has fallen so far out of favour that something more drastic than the recently announced pounds 400m share buy-back might be necessary.