Why I’d shun 20% faller Hill & Smith and buy Centrica’s 8% yield

Roland Head backs a turnaround at Centrica plc (LON:CNA) but says it’s too soon to be sure of Hill & Smith Holdings plc (LON:HILS).

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When I last wrote about FTSE 250 engineer Hill & Smith Holdings (LSE: HILS) in April, the company had recently celebrated “record revenue and underlying earnings performance”. This firm — which makes infrastructure products such as road barriers and plastic piping — was celebrating 15 consecutive years of dividend growth.

What management doesn’t seem to have expected was a shortfall in orders during the first half of the current year. Shares in the Solihull-based firm fell by more than 20% in early trade on Wednesday, after the company said that pre-tax profit fell by 14% to £28.9m during the first half of the year, despite a 1% rise in revenue.

Chief executive Derek Muir said that delays to spending on road and utility projects were to blame, along with “a more cautious UK investment environment”. An increase in raw material costs also hit the firm’s operating profit margin, which fell from 13.3% to 11.7%.

Although performance is expected to improve during the second half, Mr Muir doesn’t expect to make up this shortfall. I see this as a profit warning, and the stock’s 20% haircut suggests that other investors share my view.

Still a good business

In my view this remains a good business for long-term investors. This company has a long history of stable profit margins and strong cash generation. The dividend should remain safe, and Hill & Smith’s focus on products which must pass tough regulatory standards means that it’s not readily undercut by cheaper rivals.

However, today’s news suggests to me that profits during the second half of the year could also be lower than expected.

After today’s fall, I estimate the stock trades on a P/E of about 15. That’s not especially cheap, so I think it makes sense to wait for an update on trading before putting fresh money into this stock.

Unloved and unwanted

Utility companies are under pressure to cut costs. This could be bad news for Hill & Smith, but it might be good news for Centrica (LSE: CNA), whose stock is trading at 15-year lows.

Price caps, the threat of renationalisation and cut-throat competition from smaller rivals are all causing problems for the big utility companies. This sector is seriously out of favour. But for Foolish investors, I believe there could be an opportunity here.

Higher energy prices could lift profits

The group’s recent half-year results showed a 4% fall in adjusted operating profit. And at £1,252m, last year’s operating profit was only half the £2,586m reported in 2013.

Centrica shares have fallen by more than 60% since September 2013, and are now priced for a pretty dire future. In my view, this gloomy outlook is overdone.

The group’s finances remain stable and the shares now trade on just 11 times 2018 forecast earnings, with a dividend yield of 8.1%. Although this generous dividend is still at risk of a cut, even a 25% cut would still provide a 6% yield.

Centrica still faces problems, notably at British Gas, where customer numbers are continuing to fall. But there are early signs of progress, and higher energy prices should benefit other parts of the group’s business.

At current levels, I think this utility stock could be a good turnaround buy.

Should you invest, the value of your investment may rise or fall and your capital is at risk. Before investing, your individual circumstances should be assessed. Consider taking independent financial advice.

Roland Head owns shares of Centrica. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

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