British Steel's brittle outlook

A TOWERING performance from British Steel last week may have convinced many of the 200,000 remaining small investors - half the number who bought in at privatisation in 1988 - that this remains a stock to build a portfolio around.

Profits for 1994-5 increased seven-fold to pounds 578m. The shares soared towards their high of 180p, compared to 125p at privatisation in 1988. Forecasts for next year rose to as much as pounds 1bn, and there was praise for the management team, led by Brian Moffat, which over the years has cut the workforce by four-fifths and at one point made the company the world's most profitable steel producer.

It's hard to believe this company belongs in an industry synonymous with industrial decline and unrest, from the Rust Belt of Pennsylvania to the silenced mills of Ravenscrag and Consett - an industry which, as the National Westminster analyst Edward Hadas puts it, "like textiles, shouldn't really exist in Europe".

That's because it is relatively low value-added, making it less attractive to advanced economies than hi-tech industries or financial services.

With perhaps only a year to go until world steel prices peak, the case for holding British Steel depends on the prediction that the next downturn in demand will be less extreme than previous ones. The company is therefore undervalued, one theory goes.

Demand for steel from sectors such as construction and the motor industry is indeed highly dependent on the economic cycle - after all, British Steel was making losses only two years ago.

The present upturn in the world's economies cannot last forever. But John Graham, who follows the company at the merchant bank S G Warburg, sayst the next downturn will not dent the steelmakers too hard.

"Car production in Britain, for example, is on a growth path, to 2 million cars a year by the end of the decade, compared to 1.45 million now," he says. The Italian steel producers, responsible for some suicidal pricing in the last recession, are less likely to repeat this after the privatisation process that has swept the Continental steel industry, Mr Graham believes.

The trouble is, however, that Europe has about 20 per cent more capacity than it needs to meet its own requirements. Most countries have seen cuts in capacity in recent years, but subsidies and job protection have long been a way of life in an ageing and politically sensitive sector. So when the next European downturn comes, everything will depend on the ability to export.

However, demand from China, for example, has already fallen off, and British Steel has so far failed to build local capacity in the fast-growth markets of Asia.

Against that, the collapse of demand in the former Soviet Union and Eastern Europe since the fall of the Berlin Wall is history. At the same time those regions, with lower labour costs than Western Europe, may be able to bring into production some new or inactive capacity.

British Steel can point to some impressive improvements in competitiveness, but even in the year just ended it complained that it could not increase its share of the British market because of low-priced imports from Central Europe.

So there is good reason to be pessimistic both on the supply and the demand side. Even the French Treasury seems to share this view, as it plans to float state-owned Usinor Sacilor on a multiple of only three times prospective earnings.

True, that has a lot to do with past privatisation problems, but it makes British Steel look full-priced at four times earnings, even though that is way below market average.

There is no rerating in prospect. The only real reason for hanging on to your British Steel shares would be for the yield. On Warburg's forecast, the dividend of 7.5p for 1994-5 is likely to rise to 10p next year and 12.5p in 1996-7, giving a yield of 9 per cent. John Graham reckons there will be at least enough capital uplift to match the market in terms of total return.

But yields only reach those levels for a reason. Shareholders saw their dividend cut almost to nothing in 1992-3, and the current net cash pile of pounds 200m is below the company's targeted sum to cushion the next downturn. The tax charge is rising. The shares have been as low as 45p since privatisation and have underperformed the FT-SE 100 over the period.

For shareholders constructing a portfolio to hold for more than a year or two, it's time to cash in. Put the money into a share that doesn't rely so much upon guesses at the peaks and troughs of steel prices and the economic cycle.

Activities Steel making.

Share price 174.25p Prospective yield 8% Prospective price-earnings ratio 4 Dividend cover 3.8 1993/4 1994/5 1995/6* Turnover pounds 4.2bn pounds 4.8bn pounds 5.3bn Pre-tax profit pounds 80m pounds 578m pounds 920m Net profit pounds 70m pounds 471m pounds 662m Earnings per share 3.45p 23.2p 32.7p Dividend per share 2.0p 7.5p 9.5p (*forecast)