Smaller companies: Wyko engineers a strong comeback

SUCCESS breeds success in the stock market. Years ago, a research paper by Greenwells, a broker that has since been swallowed up, explained the ability of some companies to maintain strong growth by arguing that successful businesses enter a virtuous circle of achievement. An exciting moment is to identify a company making the transformation from spiralling failure to virtuous success. An example of a group in this happy position now is engineering distribution specialist Wyko at 114p.

There are clues when a business is on the turn. The most obvious is a change of management. Major shareholder, founder and chairman of Wyko, Philip White, realised he had a problem in the early 1990s as his group struggled with recession. His answer was to recruit as his new managing director Richard Johnson, previously a senior manager at the engineering and metals giant IMI. A little later, Johnson was joined, also from IMI, by the new finance director, Geoff Winters.

The next clue is the classic "kitchen sink" operation. When a company knows it is going to have a bad year, it is tempted to pile into the figures every piece of bad news and clear the decks for the new management to shine thereafter. At Wyko, that happened in the year to end-April 1994 when pounds 4.2m of losses included pounds 598,000 of exceptional operating expenses and pounds l.57m to dispose of discontinued operations.

But it would be a mistake to suppose that the subsequent rocket-powered improvement in trading is just an accounting trick. It is clear that the group has been refocused, and that a clear strategy and operational improvements are taking place at all levels of the business.

The main objective has been to make Wyko a leading player in the overnight distribution of engineering parts, mainly in the UK but also worldwide. This is not dissimilar to the strategy that has turned Farnell and Electrocomponents into long-term growth stars in the electronic distribution sector. The strategy had already begun with acquisitions under Mr White and has continued with deals in 1995 that boosted Wyko's branch network to 84, including a recently acquired chain in Scotland, against a quarter of that number in the early 1990s.

Allied to tight cost controls and a focus on areas where the group has expertise and can add value, this is building sales and improving margins. Wyko was well placed for fireworks because its operating margins were depressed (in low single figures) against the 13 per cent plus achieved by the market leader, Brammer. Mr Winters argues that, given sales now, there is no reason why Wyko should not, in time, match Brammer's level of profitability.

The numbers are moving rapidly in the right direction. The group's recent interim results presentation showed industrial distribution profit margins climbing from 2.1 per cent in the last six months of the 1993-94 financial year through 5.3 and 6.5 per cent to reach 7.2 per cent in the first half of 1995-96. A further improvement is odds on for the second half of this year.

There are reasons for expecting the group's excellent performance to continue. Last year's acquisitions are coming through strongly in current trading. One, Olympic Chevin, was acquired on what is likely to prove a p/e multiple of four. The group is also seeking planning permission for a new central warehouse and administration at Halesowen to replace four facilities. This should be operational by October.

Last, but not least, is the scope for further deals. The strength of Brammer and Wyko is putting pressure on smaller players to sell, with Wyko an obvious buyer. Mr Winters says there is some pounds 100m of turnover fragmented among smaller private groups and a number of possible acquisitions are being actively examined.

Distribution turnover was around pounds 36m in the first half and the belief is that economies of scale once annual turnover tops pounds 100m could take margins to 10 per cent, implying divisional operating profits of pounds 10m.

That is a mouth-watering prospect for a group that has just reported interim pre-tax profits of pounds 2m and one for which analysts are forecasting full-year profits of pounds 4.6m. Further out, analysts expect pounds 6.1m for 1997 and pounds 7.6m for the year to end-April 1998.

On those figures, the earnings per share progression is 6.0p, 8.0p and 10.0p to drop the p/e multiple to 11.3 for 1998. It is not spectacularly cheap, but deals could see those numbers significantly improved, and the shares still look excellent value.