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CORPORATE PROFILE – Letting off some steam

For years, British businesses have been told to stop being insular and get out and do business in Europe and the rest of the world. While many companies have been happy to stick within the confines of their own back yards, the Cheltenham-based engineering contractor Spirax-Sarco Engineering has taken the exhortation to heart.

The company is now regarded as one of the world’s leading suppliers of products and services for companies using steam in their manufacturing process, advising customers worldwide on its control and efficient use.

A true British success story, Spirax-Sarco posted its 29th consecutive year of increased operating profits in 1996. Although interim reports for the first half of 1997 saw a continued increase in operating profit margins, the rate of growth had clearly slowed and turnover had fallen by 4% for the period. Could one of the longest honeymoons in the history of British business be coming to an end?

Spirax-Sarco, like the rest of the British engineering sector, has been hit hard by the continued strength of sterling and the company’s accounts and its share price are beginning to show the strain. A huge 87% of the company’s business now originates outside the UK, but it is the group’s involvement in Asia and South Korea that is beginning to create a distinct lack of confidence among analysts.

The company’s single biggest exposure in the Far East is its manufacturing and sales operation in Korea and this has proved a hindrance to both profits and confidence because of the country’s recent currency crisis and dealings with the International Monetary Fund. Spirax-Sarco may traditionally have been regarded as a sound investment, but the question remains as to whether the company can use its established position in the market to pull through the current climate unscathed, or whether its exposure will cloud the rest of the company’s financial performance.

Spirax’s 1996 annual report looks healthy enough, with turnover, operating profit and profit before taxation all increasing (see page 34). But while all the indicators are pointing the right way, things are beginning to slow down. For example, the rate of turnover growth almost halved in 1996 from 15.3% to 8.2%.

The operating profit margin in 1996 grew by only 0.2% to 17.7% from 17.5% in 1995. Net debt also edged up from #3.6m in 1995 to #14m in 1996, reflecting the acquisition in December of Netherlands-based pump manufacturer Bredel Holdings BV and its associated Bredel distribution business in the US.

As a result, gearing rose to 12.1% in 1996 from 3.1% for the previous 12 months.

It’s churlish to be too hard on a company that, at 37.1%, has recently chalked up one of its best returns on capital employed. Moreover, earnings per share rose from 33.8p in 1995 to 38.0p in 1996, while dividends per share were 14.8p for 1996 compared with 13.2p in 1995. But while it is sensible to keep the shareholders happy, the figures fail to mask the underlying problems facing Spirax-Sarco globally.

By the end of 1996, the company had become heavily concentrated abroad, employing 3,900 people in 39 companies from around the world and generating almost three-quarters of group’s profits overseas. Operations in the UK provided only 13% (#34.9m) of the group’s total turnover for 1996, whereas the rest of Europe generated 36% (#97.7m) of total turnover. For the same year, the Americas contributed 26% (#71.9), while the remaining 25% (#67.4m) of total sales were generated by companies in Asia, Australasia and Africa.

The march to expand overseas has not ended. This was evident in the company’s decision last February to further integrate its Spanish company, Industrial Mas Nieto, into its operations. Spirax increased its shareholding in the business from 50% to 95.1% and acquired the entire share capital of its associated company Mas Nieto SA.

But company chairman Chris Tappin has said that the effect of globalisation is beginning to bite. The strong pound over the last four months of 1996 reduced turnover on translation for the second half by #6m. In addition, the company exports a very sizeable chunk of its UK output, which creates additional transaction difficulties.

The 1997 interim report shows a 4% fall in turnover from #136.3m in 1996 to #131.3m in 1997. Operating profits show a slight increase of 2% to #23m, pre-tax profits have risen by just 3% to #22.4m, while the operating margin has risen to 17.5% from 16.5% in 1996 (see table). Earnings per share rose by 4% from 16.8p to 17.4p, while dividends increased by 7% from 4.5p to 4.8p.

The strong pound clearly weighed on profits, knocking #5m off the group’s sales in the first half of 1997, but if the currency effects are stripped out then sales actually rose by 7% for the same period. The effects of translation are actually masking a good underlying performance and, while it may not have been on such a grand scale as in the past, profits have still risen despite the adverse affects of the strong currency.

Some analysts believe the company has shown it can put in a performance to outweigh the significant impact of the strength of sterling. Sandy Morris, engineering analyst with Hoare Govett, thinks Spirax remains a sound bet for investors despite this hiccup in its accounts.

“Spirax’s turnover is definitely down as the figures show, but this is just due to exchange rates,” says Morris. “The 1997 interim report just reflects the impact of sterling, which is a significant impact and this cannot be denied. But Spirax-Sarco is not a major importer and so the effects are not too bad. Spirax-Sarco is almost the role model for British engineering companies. It’s unquestionably the world leader in what it does and it is one of the few companies that is truly international. Spirax-Sarco is a class act and remains a class act.

“The company definitely remains attractive to investors as it has just had its 29th year of growth and this is dramatically impressive when compared to British engineering as a whole. The market will have its short-term gyrations but Spirax-Sarco will see them off.”

But other analysts do not share Morris’s confidence. Shares in Spirax-Sarco fell in November when SBC Wallburg Dillon Reed reduced its recommendation on the stock. In August, the company received notification from Royal & SunAlliance that it no longer had a notifiable interest in the company’s shares.

The reason for this growing concern is Spirax-Sarco’s large exposure in Asia – in particular, an important subsidiary in financially troubled South Korea. While this unit has so far proved to be a vital pillar of strength for Spirax operations, maintaining its traditionally strong performance and contributing well to profits for 1996, lower rates of economic growth in the Far East during 1997 have already threatened this situation. If the region’s stockmarkets are anything to go by, much worse could follow.

Tappin shares the analysts’ concern over the Korean company’s performance in the 1997 interim report, published before last autumn’s currency turmoil and the uncertainty that has dogged the area since. As this lengthy crisis threatens to continue indefinitely, Spirax-Sarco’s potential for future growth begins to look even more uncertain.

One analyst, who did not wish to be named, says: “Spirax is probably the most exposed of all British engineering companies in this region and this has undoubtedly created a bit of a risk. The company is suffering as it is a UK manufacturer which is exporting to Korea and the main problem it will face is the fact that it is exporting to Asia during a period of financial uncertainty. Spirax is exposed to Asia both in terms of currency and a fall in the overall level of demand there.” In fact, he believes that as much as 15% of Spirax-Sarco’s operating profits come from South Korea.

“This could mean that Spirax is now trading at a discount to the market and this may make it more attractive in the long term to investors or possibly to a bidder. But perhaps the fallout from Asia will instead mean that Spirax is not as attractive as it was. It is difficult to see how Spirax (shares) can continue to trade at the premium that it has done in the past.”

The problem is that no one can predict the impact of the crisis in Asia and so it is unclear what lies around the corner for Spirax-Sarco or other British companies that have taken the call to expand their operations overseas seriously.

While in the past the company’s worldwide expansion has meant a steady increase in its annual profits and its prospects, it will be difficult in the future for Spirax to maintain its level of growth.

Another City analyst says: “Spirax should get a 30th consecutive year of growth, but only just. This year should see profit growth but next year they will have to work much harder if they are to achieve the same: the 30th year should be achieved but the 31st will be a challenge.

“In the past, Spirax has been successful as they’ve created a global network and have focused on a narrow range of product that are very added value. They have become the global leaders in that product by establishing a global network that has served as a barrier to entry for other firms and growth has resulted from this.”

But the analyst believed that this network alone would not be sufficient to see Spirax-Sarco through the difficulties ahead. He believed that Spirax was too conservative and needed to put more products through its network if growth was to be maintained.

“Spirax will face tough competition from companies that have a broader range of production and who are therefore more able to defend themselves against the currency movement. Spirax needs to make more acquisitions if they are to increase the growth – not all acquisitions are frowned on by analysts, only the larger ones.”

Both Spirax-Sarco’s group chief executive Tim Fortune and finance director David Meredith refused to comment on how the company would tackle the difficulties which lie ahead or to discuss any plans to reduce its exposure to the Asian markets. But staying tight-lipped is not an option the company will find viable with its City shareholders or with the analysts who track the company’s actions.

Joanne Offer and Arthur Piper are Freeloance journalists.

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