Rising pound checks shares boom

Squeeze on overseas earnings means leaner profits and consolidation for the year ahead, says City broker

Pre-tax profits of many engineering firms will be down by 4-5% as a result of the strong pound, predicts stockbroker Merrill Lynch.

This, together with a weaker US economy, signals 1997 as a year of consolidation for UK engineering after five years in which the sector outperformed the stock market as a whole by 40%.

UK general engineering is highly sensitive to exchange rate moves. The brokers’ research of 15 major engineers (excluding aerospace, auto parts, and defence) found 53% of revenues were generated overseas.

Merrill estimates that this year sterling will trade against the deutschmark at an average 2.60 – 11% up on 1996 – and against the dollar at an average 1.68: an 8% increase.

The adverse impact on British engineering would be partly cushioned by hedging and the tax benefits of holding debt abroad. The greater impact would be on repatriation of overseas earnings. Siebe and TI Group, for instance, generate more than 80% of their turnover from overseas subsidiaries and export little.

Just under 20% of the sector’s total revenue relates to UK exports. Major exporters include Rotork, Powerscreen, Halma, Vickers, and British Steel.

Because the strong pound reduces profitability, hitting revenues while costs are largely fixed, Merrill says, in theory, a 10% rise in sterling’s value will halve margins on exports. But many companies cover export exposure on a rolling basis. So it takes time for the impact to show.

British Steel, which sources 40% of its overseas sales from the UK, is particularly exposed. According to Merrill a 10pfennig change in the deutschmark-sterling rate impacts on profits to the tune of £100m.

And companies such as British Steel – marketing an internationally tradeable commodity – are more at risk than the specialised producers. Against this background, Merrill’s favourites for 1997 are `special situation’ engineers.

It tips British Aerospace, GKN, and FKI among the major companies; IMI, McKechnie and Glynwed among middle-rankers; then Fenner, GEI, Meggitt, and ML Holdings.

The broker has down-graded its forecasts on sector leader Siebe, arguing that its 10% organic growth target may not be met in sterling terms because of the strong pound. Merrill has cut by £13m to £415m its pre-tax estimate for the year ending in March, and by £22m to £463m for 1997-98.

However, Merrill still regards Siebe as `the premier UK engineering stock with, in our view, the strongest chief executive in Allen Yurko’.