Market expectations that a genuine economic recovery is finally upon us explain the re-rating of the General Industrials sector over the last 12 months. Even so, the grouping still lags its closest cousin, Industrial Engineering, in valuation terms. A forward price/earnings ratio of 13.8 compares with the UK market’s 15.6 times rating and the 17-times multiple afforded to the engineers.

A modest discount looks warranted given the concerns we have over the quality of and risks associated with General Industrials’ overall growth profile. We are particularly cautious on the largest constituent, Smiths Group (SMIN), although we are ultimately able to take a broadly constructive thanks to our positive stance on the sector’s other two FTSE 100 constituents, can maker Rexam (REX) and recycled packaging specialist DS Smith (SMDS).

Further down the market cap ranks, the best potential lies with undervalued foils, laminates and holographics business API (API:AIM) and also RPC (RPC), whose Vision 20/20 strategy is delivering quality growth.

The sector has two sub-sectors: containers and packaging and diversified industrials. By number the former dominates with 12 companies against just two in the diversified industrials space, namely foundry operator Vesuvius (VSVS) and conglomerate Smith. By market cap the split is more even.

Keep a lid on it

It is perfectly possible to characterise plastic or cardboard containers as commoditised products and the market does not appear to have significant barriers to entry. This makes good execution particularly important and also means there are significant benefits to being an operation of scale.

Recognising the central place of packaging in the branding of fast moving consumer goods (FMCG) products and producing lighter, less raw material intensive containers are also a way for these companies to introduce more value add to their offering. When this author interviewed RPC chief executive officer Pim Vervaat at the end of the last year he was keen to emphasise his company’s ability to produce a margarine tub with a label which covers the entire lid. It would be easy to mock such seemingly modest achievements but innovations like this can give companies an edge in what is an undoubtedly competitive and, in the West, an increasingly mature market.

In order to generate growth, many sector constituents are looking toward emerging markets. Aluminium can manufacturer Rexam already has a significant footprint in Brazil and Russia but in the last few years the company has started to target India. Consumers in the world’s second most populous country currently consume less than a can per head a year compared with a one per head per day in North America. In 2013 Rexam’s Indian volumes almost doubled, albeit from a low base.

As outlined in the Vision 2020 strategy launched by RPC last year (5 Nov ‘13) there are plans to establish a ‘meaningful presence’ outside Europe. A number of acquisitions are designed to boost its presence outside its traditional European focus, although the £1.1 billion cap is also pursuing synergistic deals in its core markets. A broadening of horizons makes sense when you consider the rigid plastic packaging market is forecast to grow 6.5% outside Europe in the next half decade against growth of just 2.7% within Europe.

Currency concerns

Like the majority of exporters most constituents of the sector face the challenge posed by a strong pound in 2014. Smiths generates half of its sales in North America so the sterling/dollar exchange rate is particularly relevant. For its part, Rexam helpfully quantifies the impact of currency movements in its annual report as follows:

• every one cent change in the dollar/sterling rate changes operating profit by £1.5 million

• every one rouble change in the rouble/sterling rate changes operating profit by £1.5 million

• every one cent change in the euro/sterling rate changes operating profit by £1 million

While Rexam is relatively less impacted by the euro, RPC and DS Smith have significant exposure here with 77% and 34% of total sales derived from mainland Europe respectively in 2013.

Input costs

The other key factor behind short-term performance is the impact of energy and raw materials input costs. This means paper for DS Smith, aluminium for Rexam and polymer (a derivative of crude oil) for the likes of RPC and West of Scotland-based flexible film specialist British Polythene Industries (BPI). In most cases companies are able to pass costs on to their customers but there can be a lag which can impact quarterly profit and loss accounts.

This has particular relevance in terms of polymer given the volatility in oil prices over the last decade. At RPC the lag between higher input costs and price increases can be anywhere between three and six months. Its ability to manage this over time is reflected in the progression in its Return on Capital Employed (ROCE).

BPI’s own ability to manage polymer prices is reflected in an increase in its operating profit per tonne from £41 in 2008 to £89 last year. DS Smith mitigates its exposure to paper prices through a heavy emphasis on recycling.

Diversified approach

Smiths more than merits its diversified industrials classification. It started out as a watchmaker more than 150 years ago and has since broadened out into industrial seals, medical devices and detectors for explosives and chemical agents to name a few of its products. Its ability to keep all of its plates spinning is in serious question though and this undermines the sum-of-the-parts valuation case which is often made by bulls of the stock.

March’s interims were soured by a weak contribution from its medical division and last month (23 May) the group warned on profits thanks to problems in its detection division, which also contributed to a trading alert last July.

The £5.2 billion cap has long been flagged as a break-up candidate. In theory this could help realise value. Numis analyst David Larkham says: ‘In a bull market such companies tend to fall prey and with the shares trading below our sum-of-the-parts valuation there is the real chance of such action.’

Smiths’ chief executive, Philip Bowman, has signalled his opposition to divestments while the company’s large pension liabilities and historic issues over asbestos claims in the USA further complicate matters.

The other constituent of this sub-sector, Vesuvius, manufactures pipes and valves used to control the flow of molten metal in steel mills. It was formed in December 2012 when Cookson demerged into two separate companies, the other being electronics specialist Alent (ALNT). In the interim Vesuvius has risen by more than 30%.

The rally since the demerger rewards the group’s improved operational performance, which has been achieved despite dwindling steel demand. Results for last year (4 Mar) reveal a 0.8% increase in the operating margins to 9.3%. Continued focus on inventory reduction is expected to yield further gains in 2014. Cash generation is very strong with a cash conversion rate of 107% last year compared to 101% in 2012.

Wheeler dealing

Unlike Smiths, which has proved reluctant to part with any of its concerns, Rexam sold its own healthcare divisions for £475 million earlier this year and has outlined plans to return £450 million to shareholders. This will be implemented by way of a B/C share scheme, which gives shareholders the choice to receive the cash either as capital or as income, or as a combination of the two.

On the other side of the coin, DS Smith remains on the lookout for deals following the successful integration of its €1.6 billion capture of Swedish rival SCA Packaging. RPC also continues to pursue an acquisitive agenda. Its latest transaction, a £255 million swoop for Hong Kong-based ACE, is expected to add around 10% to group revenues and bolster the firm’s footprint in the fast-growing Asian market.

The M&H Plastics and Helioplast operations, acquired in December 2013, have already delivered synergies ahead of expectations. The merger and acquisition push has led RPC to switch its focus to return on net operating assets (RONOA) as the pivotal key performance indicator (KPI) for the business.

This metric does not consider capital structure, unlike ROCE. This reflects the acquisitive activity which would add material goodwill on to the balance sheet and increase financial leverage. A ROCE of 20% is still the target for the existing businesses. The March 2014 financial year saw the company deliver its twenty-first successive year of dividend progression since flotation so there is every chance the firm can embellish what is an already respectable 2.8% yield.

GENERAL INDUSTRIALS

[buy_or_sell b]

SUMMARY

Unlike the industrial engineers, general industrials trade at a discount to the market. A focus on value-added products belies packaging’s apparently commoditised business profile.

Number of stocks: 14

Market cap: £17.7 billion

API

(API:AIM) 392.5p

[buy_or_sell b]

Market value: £761.4 million

Prospective PE Mar 2015: 8.2

Prospective PE Mar 2016: 8.0

RPC

(RPC) £27.11

[buy_or_sell b]

Market value: £2.4 billion

Prospective PE Mar 2015: 14.5

Prospective PE Mar 2016: 13.4

Smiths

(SMIN) £28.52

[buy_or_sell s]

Market value: £2.2 billion

Prospective PE Jul 2014: 15.4

Prospective PE Jul 2015: 14.2