Castings CGS

Castings (CGS) is one of Europe's leading foundry groups, operating from three sites within the UK. The company manufactures the ductile, malleable and grey iron castings for brackets used in the Automobile, Rail, Agriculture and General Engineering sectors. Along with most companies in steel related industries, the Birmingham based group, endured a challenging year in 2004 as margins came under significant pressure due to escalating energy and raw materials prices. However we believe that Castings is ideally positioned to take advantage of expected margin improvements this year as higher costs are passed on to customers.

We consider the group's most recent interim result to be remarkably resilient given current cost pressures. Encouragingly, demand has remained strong with turnover in the six months to September 30 increasing by 8.4 percent to £31.5 million. Reduced margins have however resulted in pre-tax profits declining to £3.8 million from £4.0 million the previous year.

The steel industry in general faces a significant challenge as input and energy prices continue to skyrocket. Electricity price increases have been unprecedented in the past year. The effect of strong demand for coke and coal, primarily as a result of consumption in China, has led to their costs increasing dramatically as well. The rapid growth of China, the world's largest consumer of coal, is expected to maintain upward pressure on prices in 2005.

Steel scrap, Castings' primary raw material has also fallen victim to tight supplies and high demand, sending prices ever higher in 2004. Export bans, quotas and taxes in some countries such as Russia and Ukraine are exacerbating the shortages of scrap. Given Castings uses approximately 65,000 tonnes of steel scrap a year, we estimate a US$50 per tonne change in price lasting one month impacts the expense base by £270,000. In addition, given the recent price volatility of steel scrap it is not surprising that management have refrained from giving guidance on near-term profitability.

Due to the industry-wide nature of these cost issues we believe it is inevitable that the prices for steel-related products will continue to ratchet upwards. In this environment we are confident that Castings will be able to boost margins by recovering cost increases from their customers. CGS has already embarked on this exercise, hindered only by a small number of fixed price contracts and the scrap price volatility previously mentioned.

With the prospect of margins recovering we believe that the outlook for sustained earnings growth is excellent. Production and sales have remained strong and we were heartened to hear from management that the company has "a full order book and high schedule demands". Previous capital investments have also left Castings with the modern production facilities needed to grow market share in the future.

In the meantime, we remain confident that Castings has the financial strength to withstand current market conditions until margins recover. The company has £24 million cash in the bank, no long-term debt and tangible asset backing of 139p. Fundamentally, we believe, the shares offer compelling value with a prospective price earnings multiple of 15 times and a healthy yield exceeding 4 percent.

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