A margins make-over

Swallowfield, the contract manufacturer of aerosol and cosmetic products, was first recommended as a buy up to 86p in February (FAT22). Our investment rationale was that following a significant capital investment programme SWL was well positioned to capture future revenue and earnings growth. In light of last week's results announcement, we continue to regard SWL's valuation as compelling, and we are encouraged that profitability has improved in the last year despite increasing competition from low-cost offshore suppliers.

Since our last review (FAT30) SWL has traded quietly in the charts. This period of consolidation follows a robust rally during February that resulted in the shares reaching a five month high of 90p. The dominant pattern on the charts is a downward trend channel that has been in place since 2001. A breakout from the channel would signal that upward momentum was building, and that a lasting recovery is underway.

Swallowfield recently released financial results for the year ending 30 June 2004, recording a credible 13 percent improvement in earnings per share to 7.2p. The result was characterised by improvements in gross profit margins and operating earnings, although sales revenue dipped.

SWL's 2004 operating profit (before exceptionals) grew an impressive 40 percent to £1.98 million as a result of margin gains and a significant turnaround in the underperforming cosmetic products business. While cosmetics sales fell 11 percent to £12.2 million, operating profit improved significantly to almost break-even, compared to a loss of £804,000 in 2003

We were also pleased by the resilience of operating profit in aerosol products. While the business experienced a disappointing 11 percent decline in sales to £36.5 million, operating profit only fell 11 percent to £1.99 million. We would have anticipated profit falling by a greater extent with such a decline in sales.

The decline in sales in both cosmetics and aerosol products are a negative, however we are encouraged to see gross profit margins strengthen from 14.6 to 16.5 percent, with a resultant solid improvement in operating profit. We are also impressed that total profitability increased at a time when sales revenue declined. In our opinion this demonstrates sound management focusing on more profitable business. It also raises our confidence that management will deliver on promises of raising return on shareholders equity from 9 percent presently to 15 percent by 2009.

SWL's net profit after tax of £816,000 represented a 14 percent increase on 2003. The bottom line result would have been more robust had it not included £396,000 in restructuring expenses. These restructuring expenses however have a quick payback, with expected savings in overhead costs of £400,000 annually from 2005.

Swallowfield expects the market for personal care products to remain very competitive, with local retailers continuing to squeeze supplier margins. In addition the company expects cheaper far-eastern sourced product will progressively take a larger slice of the UK and European markets. This is the rationale for Swallowfield recently opening a procurement office in China. The office is expected to cost approximately £400,000 per annum to run, with management confident it will generate net procurement savings from 2006. We fully support the action being taken by management to diversify the company's business model into distribution as this should ultimately allow SWL to boost margins and arrest a decline in market share.

We are pleased that SWL's balance sheet strength has been maintained in spite of somewhat challenging trading conditions. Year end net debt of £8.8 million is in line with 2003, and interest cover remains solid at more than 4 times.

SWL's investment fundamentals remain compelling with a prospective price earnings ratio of 7 times and dividend yield in excess of 6.5 percent. In addition Swallowfield is solidly back by tangible assets of 85p per share, after accounting for the company's £2.5 million pension fund deficit. Technically, further consolidation is possible in the near term although downside appears limited. As such SWL will remain firmly held in the Fat Prophets Portfolio.