Castings 12 Feb 04

All cashed up

Castings (CGS) is one of Europe's leading foundry groups, operating from 3 sites within the United Kingdom. Shares in the manufacturer have been under pressure recently due to last month's adverse trading update. Castings' margins are being squeezed due to increasing raw materials costs, and tight customer demand. However, we believe CGS' iron-clad balance sheet will enable the group to "weather the storm" until normal trading conditions resume. In our opinion, the current price action has provided an excellent opportunity to gain exposure to this well-managed company at an undemanding valuation.


"CGS' asset backing is incredibly sound with no intangibles, zero term debt, and cash of around £23 million on the balance sheet.."

CGS manufactures the ductile, malleable and grey iron castings for brackets used in the Automobile, Rail, Agriculture and General Engineering sectors. Castings' origins date back over 100 years, to the establishment of the group's cornerstone business, William Lee. In recent years, management has invested around £17 million in CGS' production facilities which are now state-of-the-art. The group's customers include many European vehicle manufacturers as well as several railway companies worldwide. Management have fostered a culture of strict quality control throughout the group with a philosophy of 'Continuous Improvement'.

cgsd1202.jpg

CGS was one of the star performers of the early to mid 1990's, with the stock increasing more than eightfold from 36p to an all time high of 300p in 1997, as the engineering sector flourished. While it is not unusual for out-performance to persist for many years, at some point market conditions always turn, with the result often being a deep correction. This was the case with CGS which declined by almost 60 percent from the record high, to a low of 125p, tracking the downward trend in UK industrials. Although the share price has since rebounded somewhat, CGS remains a long way below peak levels.

We were encouraged by the company's steady interim results to 30 September 2003, especially given they were achieved in the face of soft demand from CGS' automotive customers, and the depressed state of manufacturing in the UK. Castings managed to increase turnover by 4.4 percent to £29 million, although increasing costs meant that profit before tax fell by 3.6 percent to £4,033,000. CGS has suffered margin pressure due to unprecedented rises in raw materials with scrap-iron prices increasing from £65 to £105 per tonne during the year. As a result, operating margins fell from 12.9 to 12 percent.

In January the shares pulled back from a two-year high as Castings announced that weakening demand, and further raw materials price increases would weigh on margins. This revelation was not surprising given the increasing price of scrap iron. In recent weeks ferrous scrap prices have reached over US$200 per tonne due to ongoing tightening in supply and continued strong demand. Steel makers are facing substantial cost increases due to rising coal, coke, and energy prices. In addition, ocean freight costs have skyrocketed as China's huge demand for raw materials has severely strained the available supply of vessels. The last time the industry faced pressures on a similar scale was during the energy crisis in the 1970's. This heralded a period of stagnation in steel demand across most western industrial countries and ultimately led to closures of uncompetitive steel-making capacity.

Nevertheless we believe there are reasons to be optimistic about the impact of rising input costs on Castings. Firstly, it is our view that the US dollar (in which raw materials are priced) will continue to weaken against the Pound. This should mitigate the effect of increases in USD scrap iron prices on CGS' earnings. In contrast, the majority of Castings' foreign customers are European-based and the simultaneous strengthening of the euro should prevent any adverse effects on turnover. Secondly, we believe that Castings, unlike some competitors, is well positioned to withstand margin pressures. The group's operations are highly efficient following significant capital investment, and the company has an extremely robust balance sheet.
cgsw1202.jpg

CGS' asset backing is incredibly sound with no intangibles, zero term debt and cash of around £23 million on the balance sheet at 30 September 2003. We expect the company's cash balances to continue growing. Castings' pension deficit was cleared during the year and the programme of heavy investment in the foundry business has been completed. The manufacturer is still investing to improve productivity and expand machining operations, but capital expenditure should fall to around £3 million this year, compared to £7 million in 2002.

A further encouraging prospect for shareholders is that CGS is considering paying a special dividend in 2004 as long as cash balances are maintained at around £20 million. While there is no guarantee of the payout, year end cash estimates suggest the dividend could be anywhere between 7 and 14p a share.

Following some solid gains during late 2001/early 2002, CGS has mostly traded in a large range between 195p and 145p. In our opinion this range should ultimately provide the base for the next advance, which we expect to be driven by improving industry dynamics, and compelling company fundamentals. We regard the current trailing price earnings multiple of around 13 as fairly inexpensive, given the shares also yield around 5 percent (with the prospect of this being boosted by the special dividend).

With prices currently trading within the lower half of the range, we believe that an excellent entry opportunity has arisen. While further consolidation cannot be ruled out, CGS is currently trading at historically low prices, so in our opinion downside risk should be limited. Accordingly, we recommend CGS as a buy for Members up to 168p.

DISCLAIMER

DISCLAIMER Fat Prophets has made every effort to ensure the reliability of the views and recommendations expressed in the reports published on its websites. Fat Prophets research is based upon information known to us or which was obtained from sources which we believed to be reliable and accurate at time of publication. However, like the markets, we are not perfect. This report is prepared for general information only, and as such, the specific needs, investment objectives or financial situation of any particular user have not been taken into consideration. Individuals should therefore discuss, with their financial planner or advisor, the merits of each recommendation for their own specific circumstances and realise that not all investments will be appropriate for all subscribers. To the extent permitted by law, Fat Prophets and its employees, agents and authorised representatives exclude all liability for any loss or damage (including indirect, special or consequential loss or damage) arising from the use of, or reliance on, any information within the report whether or not caused by any negligent act or omission. If the law prohibits the exclusion of such liability, Fat Prophets hereby limits its liability, to the extent permitted by law, to the resupply of the said information or the cost of the said resupply. As at the date at the top of this page, Directors and/or associates of the Fat Prophets Group of Companies currently hold positions in: ASX-listed Australian stocks: ASX-listed Australian stocks: AAC, AAD, AGO, AJA, AMP, ANZ, APA, APG, AVG, BCI, BHP, BKN, BOQ, BRL, BRU, BTR, BWP, CBA, CCL, CDD, CFE, CGL, CKF, CNQ, CVO, CWN, DLS, DNX, DUE, ELD, ENV, EVN, FID, FMG, FXJ, GJT, GMG, GNS, GOR, GPT, GXL, HUB, IAU, IFL, ILU, IMF, JHX, MFG, MGR, MML, MMS, MND, MNF, MPL, MTR, MTU, NAB, NCM, NMG, NUF, OBS, ORE, OSH, OVH, POS, PPS, PRG, PRT, PXG, QAN,QBE, RIO, RXL, RRS, S32,SDG, SFR, SGP, SIV, SLR, SPK, STO, SUN, SYD, TAM, TEN, TLS, TME, TTN, WBC, WFD, WES, WHC, WOW, WPL, WSA. International stocks 3i Group, Acacia Mining, Amec Foster Wheeler, Anglo American, Archipelago Resources, Arian Silver Corp, Aviva, Avocet Mining, Bank of China, Barratt Developments, BMW, Berkeley Energy, BG Group, BOLSAS Y MERCADOS ESPANOLES,SOCIEDAD, Bovis Homes, BP, Braemar Shipping Group, British American Tobacco, BT Group, Cairn Energy, Centamin Egypt, China Life Insurance, China Mobile, China Overseas, China Taiping, China Vanke, Country Garden, Daejan Holdings, Development Securities, Dragon, Enquest, Esure, Euronext, FedEx, Fresnillo, Ibiden, Infosys, Glaxosmithkline, Glencore International, Goldbridges Global Resources, Google (Alphabet), Grainger, Gulf Keystone Petroleum, Highland Gold Mining, HSBC,ICICI Bank, Ironveld, iShares Physical Metals, J Sainsbury, JKX Oil & Gas, John Wood Group, Kazakhmys, Legal & General, Lloyds, Low and Bonar, Market Vectors Junior Gold Miners, Market Vectors Oil Services, Market Vectors Vietnam, Marstons, Medusa Mining, Mitchells & Butlers, Mitsubishi Tokyo Financial, Mitsubishi UFJ, National Grid, Nippon Telegraph and Telephone, Panasonic, Paragon Group of Companies, Petra Diamonds, Petrofac, Petropavlovsk, PICC Property & Casualty, PPHE Hotel Group, Randgold Resources, Rank Group, Reckitt Benckiser, Royal Dutch Shell, Solgold, Sony Corporation, Standard Chartered, STV Group, Sylvania Platinum, Tata Motors, Tencent, Tertiary Minerals, Teva Pharamaceutical, Toyota Motor, Tullow Oil, Unilever, Vedanta Resources, Vodafone, Walt Disney, Zillow.