Spilt milk takes shine off Pilks

The venture capital group 3i, already Europe's biggest, is celebrating its 50th anniversary in fine style. Shares in what is now the UK's largest investment trust were floated at 272p last July and have been one of the best performers in the FT-SE 100 index since, outperforming the average by 25 per cent.

They shaded 5p to 367p yesterday after the group disappointed the market by revealing net assets growth of just 10.5 per cent for the year to March to 346p per share. But there was no shortage of praise from brokers, pleased with a rise in pre-tax revenue earnings from pounds 65.4m to pounds 75.8m in the year and a 10 per cent dividend hike to 7.2p.

A classic cyclical stock, 3i has benefited as the afterwash of economic recovery finally catches up with the small- and medium-sized companies in which it invests. Earnings from its investee companies climbed by around 25 per cent during the year and demand for capital continues to rise. In total, 3i pumped pounds 454m into 532 companies, compared with pounds 315m in 536 the previous year, raising its UK market share from 17 to 25 per cent.

But 3i has been unable to avoid the effect of last year's stock market fall. A drop of nearly 21 per cent in the FT-SE SmallCap index cut the average p/e ratio used to value the largely unquoted portfolio to 11.2 from 14 in March 1994.

That reduced the unrealised appreciation in the portfolio to pounds 113m from pounds 394m the previous year, although realisations - mostly trade sales - rose from pounds 55.6m to pounds 77m.

Since the year-end, the market for quoted smaller companies is up 9 per cent, which Hamish Buchan of NatWest Securities suggests should mean that the shares are now trading around net asset value. But if the current SmallCap p/e ratio is maintained, net assets could rise to 425p a share by next March.

Further growth is almost assured by the fact that these results are based on profit figures from investments nearly a year old, but two factors suggest a degree of caution. Any remaining unsatisfied institutional demand - a big factor in last year's share price performance - should be met by next week's sale of 21 per cent of the stock by several of the big bank shareholders. More important still will be the performance of the UK economy. Even so, the shares should have a little further to go.

It would be wrong to dismiss Pilkington's pounds 392m goodwill write- off as nothing more than an accounting technicality - it represents real money that the company spent seven years ago and subsequently squandered. But it is spilt milk and irrelevant from a forward-looking investment perspective.

The write-off did, however, knock a serious hole in results for the 12 months to March, taking the shine off underlying profits right at the top end of expectations. The pre-tax loss of pounds 248m disguised a doubling of normalised profits to pounds 144m; a 5 per cent rise in the dividend to 4.2p is a better indication of progress than the reported 40.7p loss per share.

The recovery is well under way in Pilks' automotive and building markets but the results should be seen in context. The five-year record conveniently hides the fact now, but the company made profits of over pounds 300m in 1990 - there is still a long way to go.

Most of the key numbers are moving in the right direction, finally. Volumes were up in all regions, with North America and the rest of the world outperforming Europe, which is on a later cycle and yet to fully recover. Capacity is also rising encouragingly, which for a business with such high operational gearing is crucial.

Margins are pleasantly up, thanks largely to a highly successful cost- cutting programme adding up to pounds 230m over the past three years. Working capital has also been ruthlessly stripped out of the business. Productivity, up a further 8 per cent last year, has risen relentlessly since 1991.

The fly in the ointment remains prices, which are still under the cosh. In Europe, overcapacity in the downstream double-glazing market remains a depressing factor.

In the US and Europe, the buying power of the large car makers means windscreens are fetching 20 per cent less than four years ago.

The keys to the shares are where we are in the cycle, the margins the company believes it can achieve at the peak and what is an appropriate price-earnings discount at that stage to take account of the company's extreme cyclicality.

With the US close to topping out, peak earnings can probably be expected in 1997 when the company reckons it can make a return of 11 per cent on sales. That gives profits of pounds 327m and earnings per share of 23p.

What price to put on those earnings? The market is currently on 10.8 times 1997 forecast earnings, a discount of about 20 per cent seems reasonable and so the shares should rightly be priced at just over eight times that year's earnings. At 190.5p, the recovery is already in the price.

3i shares can go a little further

Some drugs worth buying

Trading starts next Friday in the newly floated shares of Meconic, the UK's sole producer of pain-killing opiates such as codeine and morphine. The decision to push for a market value of pounds 44.4m, compared with estimates of pounds 40m, and strong demand from institutions and those private clients in on the placing, suggests a strong opening for the shares.

Meconic (the name comes from the Greek for poppy) has a history dating back to 1780 and a Scottish surgeon apothecary called John Macfarlan. More recently, the company was acquired in 1963 by Glaxo, from which its management bought it in 1990.

Since then, profits, margins and return on capital have grown smartly, while the company's strong cash flow has been used to pay down a substantial proportion of the debt taken on at the time of the buyout.

The placing of 7.4 million shares at 135p will raise pounds 18.7m for the company and pounds 8.7m for existing shareholders, mainly 3i, which remains a significant shareholder, and NatWest Ventures, Noble Grossart and the Bank of Scotland, which do not.

The proceeds are to be used to expand Meconic's small fine chemicals operations (20 per cent of sales) to complement its pharmaceuticals niche. The company focuses on highly specialised products with little competition.

Encouragingly, there has been good demand for the shares from staff, with over two-thirds of the 200-strong workforce investing. The directors are also net investors.

With no directly comparable company on the market, Meconic has been priced according to the speciality chemicals sector, its closest proxy. Companies such as Croda, Holliday, BTP and Yorkshire Chemicals are currently trading on historic p/es of about 16, so Meconic's placing price of 14.5 times pro-forma 1995 earnings looks sensible. There is a notional 4.1 per cent yield.

In fact, given the high barriers to entry of the opiates market, Meconic's dominance of it and its growth prospects, the rating could well prove quite generous.