Why I'm avoiding James Halstead plc despite positive Brexit effects

Commercial flooring company James Halstead(LSE: JHD) has released a mixed update today. On the one hand, the company has benefitted from weak sterling as much of its business is made up of exports. However, it has also been hit by challenges regarding cost rises and a reduction in demand in the UK. But there's another key reason why I'm avoiding it for now.

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Brexit boost

The main impact of Brexit has been a depreciation of the pound. This has helped to boost James Halstead's margins on its overseas sales, while making the company more competitive versus international peers. Although there are off-setting impacts from weaker sterling, such as price pressures on imported goods, the overall impact has been positive.

Looking ahead, it would be unsurprising if the value of the pound weakened further. The UK hasn't yet invoked Article 50 of the Lisbon Treaty and so uncertainty has the potential to rise. That's especially the case since both sides in the negotiations seem to be somewhat stubborn in their demands at this stage. While a deal may be reached within the two-year negotiating timeframe, the reality is that uncertainty may move higher during that time and cause the pound to weaken.

Weak trading

The positive effects of weak sterling have been offset by difficulties within the UK market. James Halstead's market share in the UK hasn't fallen, but the market for its goods is lower than last year. The best estimate of this is a reduction in demand of between 4% and 5%. This trend could continue in future, since most forecasts indicate a slowing down of the UK economy in 2017.

In addition, there has been significant upward pressure on the pricing of one of the company's raw materials, plasticiser. This is due to reduced supply following an explosion at one of BASF's European plants. While James Halstead has been able to access appropriate volumes elsewhere in the market, prices have moved higher due to an imbalance between demand and supply. This is likely to continue throughout the remainder of the year, which could negatively impact on the company's financial performance.

And the outlook is...

James Halstead is expected to report a rise in earnings of 6% in the current year. While this is in line with the wider index, the company's price-to-earnings (P/E) ratio of 25.5 indicates that it's priced as a growth stock. Given the challenges faced in the UK market and the impact of supply disruption, it would be unsurprising for the current valuation to come under pressure.

Sector peer Balfour Beatty(LSE: BBY) is forecast to report a rise in earnings of 46% next year. Despite such a high growth rate, it has a lower rating than James Halstead. Balfour Betty's P/E ratio of 23.6 shows that there's scope for a significant share price rise over the medium term. It also offers a wide margin of safety, which means that if trading conditions worsen due to Brexit then its share price may still perform relatively well. As such, Balfour Beatty remains a sound buy, while James Halstead is simply overvalued.

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Peter Stephens has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.