HG Metal @ 49 cents ( Metals / Singapore ) 3 comments

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Main issues

1.Cyclical steel industry means PE should be taken in context

2.Latest results show signs of margins slackening

The earnings trend has already started to slacken. HG Metal has surged up over the past year due to the commodities bull market, earning extraordinary gross margins on their steel inventory. The latest 1H2005 results a few days ago has just revealed that gross margins have fallen compared to the corresponding quarter in 2004. Even if revenue remains strong as was so in 1H2005, it is clear that increasingly high operating overheads will be needed to support sales and distribution for higher revenues, which could eventually combine with peaking margins to overwhelm gross profits.

Don't be tempted by the low PEs associated with HG Metal. The steel industry is a typical cyclical sector. Fluctuations for such sectors (another example: shipping) tend to be more pronounced because of a variety of reasons. Firstly demand tends to lead to over-investment in increasing supply which once in construction cannot be scaled down easily and flexibly (due to high fixed costs characteristic of these sectors), hence pulling down rates and pricing power. Secondly they're far-removed from the final consumers (as opposed to say, retailers) which makes it difficult to forecast demand even for their top management (think Chartered as well in this case).

Watch out for its report card for the second half of 2005.

References:
(1) Steel price trends
(2) HG Metal latest half-year financial statement