Edmond Jackson's Stockwatch: Take care with this newly-listed small cap

Strong interim results from Polypipe Group, the £475 million FTSE SmallCap manufacturer of plastic pipes for construction, affirm UK economic recovery and its exports to the Middle East are also doing well despite performance in continental Europe (principally France) being quite flat. In 2013, revenue derived 75% from the UK, 20% Europe and 4% rest-of-world - so the UK remains critical.

Interim profit before tax and exceptionals has jumped 66% to £16.4 million on turnover up 10.8% to £168.2 million, with earnings per share of 7.05p reasonably on target for the consensus 14.4p expected this year - implying a price/earnings (P/E) multiple of about 17 times, reducing to 13.5 if the consensus 2015 forecast is met also. The 12-month forward dividend yield is about 2.7%, nothing special but well-covered by earnings forecasts (see table).

One key reason is the boom underway in UK housebuilding where, as I noted in my mid-July piece on Barratt Developments, the international estate agency Savills projects a 55% rise to 167,000 new homes a year by 2018.

The UK's need for flood alleviation schemes after January's disasters is also boosting demand. Polypipe's outlook for the second half is more challenging due to 2013 being a strong comparator, however the Construction Products Association summer forecast shows overall UK construction output growing by 4.7% for 2014 as a whole. Management says: "We remain well-placed to capture our share of this anticipated market growth in the UK."

Mind how this optimism contrasts with a "surprise" August slump in UK house prices, although the market has looked heady with buyers scrambling to close deals. This is precisely when house prices can turn, as more supply is introduced, and concern may also be growing about an inevitable rise in mortgage interest rates. The housing market does however need some correction to support long-term growth, considering wages.

Trading play or tuck-away?

Polypipe shares initially rose from their 245p flotation price into a 250p to 265p range; then drifted until support kicked in at 235p ahead of interims - currently 248p as investors digest the results. The company should continue to perform well but mind this share and similar small-cap cyclicals may be more a trading play than tuck-away. Cavendish private equity retains a 17.8% stake hence ongoing exposure to Polypipe's fortunes; yet it was likely shrewd to re-float the business last springtime amid demand for quality cyclicals.

Many investors may not recall how Polypipe fared, 14 years and longer ago when it was previously listed. Underlying performance was fair enough but the stock languished on a single-figure P/E until listed engineering group IMI acquired it in 1999; then in 2005 private equity backed a management buyout. It took nine years for the company and market conditions to be favourable to re-float. Shrewd professionals have therefore exploited investors' torpor and enthusiasm alike - and I would tread carefully where you see a cyclical like this, its P/E in the mid-teens and based on ambitious forecasts. Indeed it may be a sign the stockmarket needs to consolidate.

The main uncertainty is political: how mortgage subsidies will fare after the 2015 general election, and the effects of a Labour majority on sentiment. Opinion polls will be volatile but Ed Milliband has lately taken a seven-point commanding lead.

To avoid turmoil the Conservatives will likely continue with David Cameron as leader and much will depend on his campaign skills; whether Boris Johnson can help re-capture votes lost to UKIP. Altogether the UK general election prospect is highly uncertain yet small-cap cyclical shares have romped on regardless - the likes of Polypipe achieving quite a "growth" rating.

Legacy debt

I therefore feel it valid to provide long-term comparison; and on a 14-year horizon for Polypipe I would stand back for now. Its recent sales to the UK residential sector represent 50% of group turnover, up 18.9% like-for-like, although 62% of this comprises repair, maintenance and improvement than new build. The UK commercial and infrastructure sector represents 32% of group revenues and is up 19.2% amid good demand from road and rail projects also more high-rise buildings in London. So the group's commercial areas are in good health and it is not mainly exposed to new build; however the stockmarket is not pricing in risk factors with the cycle, a typical sign that consolidation is needed after a strong run.

Another concern is financing costs should profits' momentum ease. While cash generation increased by 42% to £17.8 million, net debt is still high at about £100 million (up £15.6 million due to "seasonal issues") and compares with net assets of £227.2 million - wholly supported by £234.4 million intangibles. Legacy debt is a typical factor with firms previously owned by private equity, and here it means an interim net interest charge of £6.3 million covered 3.6 times by £22.7 million operating profit. This is taking a pre-exceptionals' view, there were additional charges both on operating items and finance costs during the first half. While the debt is not a big overhang it is significant for the shares' rating if the business cycle moderates.

So Polypipe's situation informs us to take care with cyclical stocks currently, where ratings may allow little scope for negative change.

For more information see polypipe.com.

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.