A well-groomed investment

Swallowfield (SWL) is one of Europe's premier contract manufacturers of toiletries and cosmetics. In recent years the company's profitability and share price have suffered due to constraints on the manufacturer's production capacity. However, SWL has now completed a programme of significant capital investment, and in our opinion, is strongly positioned to regain earnings growth. The shares are presently trading at historically low levels, and given SWL's recovery prospects, we believe an excellent buying opportunity currently exists.

Swallowfield has been developing and producing aerosol, cosmetic and toiletry products since 1950. Trading as Walter Gregory and Co, SWL was responsible for filling the first commercial aerosols, and the introduction of the first 'Own-Label' antiperspirants to the UK in 1970. The company listed on the London Stock Exchange following a management buy-out from Cadbury-Schweppes in 1986, and soon expanded into the cosmetics sector, with the 1989 purchase of Cosmetics Plus.

As a result of the company's favorable market positioning and sound expansion prospects, SWL was a well performed stock during much of the 1990's. From a low of 60p in 1992, the stock rose by a massive 375 percent to an all time high of 285p in 1998. However such out-performance never lasts indefinitely and competitive pressures drove SWL down by over 85 percent to a low of just 40p in 1999. Although prices have since rebounded off their lows, the shares remain a long way below their peak.

Currently, SWL is a significant investor in innovation with an unrivalled breadth of product capabilities. Recent investments and developments have continued to enhance the company's product range. The company now has hi-tech production facilities in Wellington, Somerset and Bideford in the UK. Swallowfield has also formed a partnership with Yves Rocher in France to develop and strengthen the company's facial skincare offering.

Swallowfield's most recent result was disappointing with the company unable to convert a strong order book into an increase in earnings. Turnover to 30 June 2003 rose by 26 percent to £54.7 million, but group profit before tax decreased from £2.3 million to £1.0 million. This trend was confirmed in each of SWL's core businesses. Although sales in the Aerosols division increased by 28 percent to £40.8 million, operating profit decreased 18 percent to £2.2 million. Earnings at the Cosmetics business also underperformed, delivering an operating loss of £0.8 million despite a 20 percent increase in turnover to £13.8 million.

In spite of these results, we are confident that SWL's current earnings prospects are considerably brighter. Ironically the problems experienced by SWL last year were due to high levels of customer demand which put a strain on the business. In 2002 three main competitors were forced into bankruptcy and this created a significant increase in orders. The rapid build-up in demand severely stretched SWL's ability to obtain quality labour and effectively utilise available plant capacity. Management was forced to hire large numbers of temporary employees, and experienced a significant increase in production inefficiencies. Short-term capacity constraints and cost increases combined with pricing pressure to dampen profitability in the first half of 2003 financial year.

We are confident that the capacity and associated overhead issues have been satisfactorily addressed by management. SWL has made significant investments into their Wellington site to address previous production constraints. The factory has been expanded at a cost of £1.6 million to provide space for future business growth, while additional investments have been made in plant, equipment and improved technologies.

We expect margins and earnings in 2004 to be significantly boosted by the manufacturing efficiencies gained from recent capital investment. Production enhancements will generate around 10 million units of additional capacity, and will allow management to drive down operating costs. Management have already reduced the annual overhead cost in the Cosmetics business by £500,000.

We are not overly concerned that the heavy capital investment programme has increased balance sheet gearing from 42 to 75 percent. Although net debt has increased from £4.9 million in 2002 to £8.8 million at 30 June 2003, we are confident SWL's balance sheet strength will increase over the coming year. We expect strong cash flows and reduced levels of capital expenditure going forward to underpin ongoing reductions in SWL's debt levels.

In our opinion, SWL's operations now provide significant leverage to an eventual upturn in current market conditions. In a recent trading statement, management revealed that order delays by customers, together with relatively subdued trading across toiletries and cosmetics continue to impact the business. However we are encouraged that management still expects full year results to be in line with expectations. We believe any signs of improving industry demand will press the case for a re-rating of SWL's share price.

Fat Prophets believe management have established a solid platform for the restoration of earnings growth at Swallowfield. Production capacity has been restored to more optimal levels and significant progress has been made in lowering operating costs. Management is focussed on product innovation and now that margins have been restored we believe this will be a key factor in driving increases in market share.

While some further consolidation in SWL's share price cannot be ruled out in the near term, we believe that downside potential is limited by the company's compelling fundamentals and sound recovery prospects. SWL is currently trading on a prospective earnings multiple of just 8 times, and carries a solid yield of 5 percent. A sustained break above trendline resistance at 88p would provide us with compelling evidence that a lasting recovery is underway. Accordingly, we recommend that Members buy SWL up to 86p.