Three Bags In One Year

Published in Company Comment on 2 August 2010

Elementis has raced ahead over the last year. Where next for the profits?

A year ago, I thought shares in Elementis (LSE: ELM) were pricing in too much bad news and not enough optimism. At the time, the company's shares stood at 29p. After Monday's results for the half year to the end of June, the shares are up over 6% to 82.25p.

So what was it about the global speciality chemicals group that made it so appealing a year ago -- a year in which the shares have gone almost three-fold, and should the shares be held or bought at today's hugely increased price?

The clues were there

OK, many shares were down on their luck a year ago, but most had already started to recover by July and few have tripled since. 

But the clues were there. The company had taken some tough decisions; closing down its chromium factory in Eaglescliffe, Durham, due to a decrease in demand from Asia -- and taking other cost-cutting measures. Production was shifted to the company's factories in Texas and North Carolina. Meanwhile, its historic price-to-earnings ratio was well under four at the then price.

At the end of June, the company told us business had "stabilized" and that it would have an underlying positive operating profit for the first half. At the time, the broker had £20m pre-tax profit pencilled in for the next two years, the balance sheet showed net assets of almost £270m, and the company remained well within its banking covenants.

Normal service resumed

Elementis, like so many others, was clearly suffering from a hiatus in demand -- albeit a very dangerous one. But it was also doing the things it should to ensure its survival, was giving us real evidence that it had turned a corner, and its previous profit levels were a reasonable indicator of the possibilities. Indeed, its share price of two years ago is roughly the same level to which it has now returned, as normal service seems to have been resumed.

The brokers today are seeing pre-tax profits of over £52m next year with earnings per share of 7.9p, placing the shares on a prospective P/E of around 10. This is hardly outrageously expensive, but nor is it the kind of bargain basement territory which was spoiling us for choice last summer.

Meanwhile, the net asset value of close to £200m evaporates when you concentrate on the tangible stuff, so it's really all about earnings going forward.

All good news now

Monday's results show a pre-tax profit of $46m for the half year, on revenue up 41% to $358m. Operating cash-flow improved to $52m, earnings per share came in at 7.3 cents (4.6p) and net debt was down $18m to $108.3m. 

The interim 1.5p dividend means the shares are likely to be yielding around 3.6% for the year, and the company says its strong order book gives it confidence in its ability to make further progress during the rest of the year. Whether this will cause the brokers to up their forecasts remains to be seen, but for my money the shares look about fairly valued for the time being.

Where next?

In other words, it's far better to concentrate on finding the Elementises of the next year or two -- mindful of the fact that macroeconomic conditions and, more crucially still, confidence levels are now in a very different place to a year ago.

Finding them is the tricky part, but there are quite a few small caps in particular yet to play catch-up

Though inherently riskier, they also present a bit more in the way of upside potential. With value micro-caps, this is even further exaggerated. For example, for my money, Pressure Tech (LSE: PRES) is now firmly back in buying territory, and interesting small cap OMG (LSE: OMG) hasn't really got motoring. 

These are just a couple of possibilities that spring to mind -- but the type of out and out bargains presented by Elementis a year ago are getting harder to find.

More from David Holding:

David owns shares in OMG & Pressure Tech.

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