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Bargains in U.S. Industrials

There's value to be found in smaller U.S. industrial names, and this screen can help you find it.

Haywood Kelly, 06/03/2009

When considering the likely bankruptcy of General Motors GM, or the incredible shrinking market cap of General Electric GE, it's easy to forget that the United States is still home to some of the best-run, most technologically advanced industrials firms in the world. And right now, many of them trade at levels that sure look compelling to Morningstar's team of analysts. While this issue's Sector Rap focused mainly on large-cap names in the industrials sector, this issue's stock screen turns up some mid- and small-cap industrials that are beaten down to attractive levels.

Price/Sales < 1.0

Price/sales tends to be a good valuation tool for industrials stocks. Sales are less variable than earnings and cash flows because operating and financial leverage magnify changes to profits relative to revenues. So price/sales gives you a smoother, more meaningful number to screen on. It's meaningful even when profits are low or negative (sales are never negative). For a cyclical stock, a low P/E can simply mean earnings have peaked and it's all downhill from here. In fact, there's an old saw that the time to buy cyclicals is when the P/E is astronomical, as that means earnings might be bottoming. For this screen, we require a low price/sales ratio--less than 1.0.

And Dividend Yield > Dividend Yield of the S&P 500

Perhaps I've been spending too much time with Josh Peters, Morningstar's dividend strategist, but I'm paying more attention to dividend yields these days. The typical industrials stock is not in the ramp-up phase of its growth cycle and therefore should be paying out profits to shareholders in the form of dividends. Given the S&P 500 dividend yield of 3.3%, I should demand at least that much from an industrial. Plus, a dividend signals that management thinks the company has the wherewithal to part with cash; other things equal, that's a good sign.

And Financial Health Grade >= B

For an industrial to make us money, it needs to make it through this crisis. So a financial health criterion is essential. We could screen by any number of financial health variables--financial leverage less than three, for example, or debt/equity less than 50%. But the financial health grade tends to be a more reliable screening tool in the sense that you get fewer false positives. Tossing out any company that fails to make an arbitrary cut-off on one of the traditional financial leverage ratios tends to (at least in my experience) eliminate too many solid companies; there's often a financial ratio that a company will look poor on (financial leverage, say, because the company has bought back a lot of shares, depressing its book equity), even if it's actually quite strong on closer inspection.

The financial health grade, in my opinion, does a good job across a variety of different types of firms. It ignores book equity (using market capitalization instead), and only relies on the book value of liabilities from the balance sheet. And even if liabilities are understated on the books, the market capitalization will often reflect the off-balance-sheet liabilities, keeping the financial health grade honest.

Here are five stocks that passed the screen and also had a 5-star Morningstar Rating for stocks as of May 1.

Tyco International TYC
Market cap: $10.5 billion
Moat: Narrow
Fair value estimate: $40
Uncertainty: Medium
Tyco International is the worldwide leader in many of its markets. This lead, combined with substantial recurring revenue, gives the company a solid advantage and the protection of a narrow economic moat.

Being the biggest is an important advantage in markets where cost structures exhibit a material proportion of fixed costs, and where overall growth is sufficiently slow so as to inhibit competitors from reaching similar scale. Tyco's largest and most well-known business, ADT, holds such a position. Its $8 billion in global revenue is more than 10% of the total market, with the nearest competitor less than half its size. A large swath of the market is made up of mom-and-pop competitors that can't match the advantages of ADT.

Hubbell HUB.B
Market cap: $1.6 billion
Moat: Narrow
Fair value estimate: $44
Uncertainty: Medium
Hubbell's strength as an efficient operator has bolstered its profitability and allowed the firm to maintain margins in the presence of a downward-turning market. Although the domestic construction markets will likely face a challenging 2008 and 2009, Hubbell has positioned itself to generate economic profits over the long run.

The electrical products industry is dominated by a few very large firms that often compete directly with one another. Hubbell's efficiency led to superior returns and allowed it to be the low-cost producer in the industry. The gap is narrowing quickly, though, as Thomas & Betts TNB and Cooper Industries CBE have spent the last couple of years retooling their businesses. However, these firms have their hearts set on international markets, which enable Hubbell to dictate its own course in the United States.

Rockwell Automation ROK
Market cap: $4.3 billion
Moat: Narrow
Fair value estimate: $47
Uncertainty: Medium

This narrow-moat firm has a history of returning cash to shareholders and has benefited mightily from efforts to diversify across geographies and end markets.

Rockwell's decision to concentrate on factory automation and controls has helped improve corporate margins and returns on invested capital.

Going head to head with industrial giants Siemens SI, Emerson EMR, and ABB ABB, Rockwell has captured market share and expanded into the growing machine-safety markets. Rockwell has used a lead in technology and partnered that with a strong distribution force to hold market-leading positions globally.

Snap-on SNA
Market cap: $1.7 billion
Moat: Narrow
Fair value estimate: $50
Uncertainty: Medium

An unparalleled ability to leverage its reputation for quality products and service has allowed Snap-on to establish itself as a premier tool supplier. Although complacency has stymied performance in recent years, operating improvements are starting to provide substantial upside opportunities.

Snap-on is one of the industry's largest manufacturers and marketers of high-end hand and power tools for professionals. Snap-on's strong dealer network has been the cornerstone of the company's marketing prowess over its 88-year history. Its dealers are franchise operators that provide sales, service, and financing to customers at their place of business. A service-focused distribution strategy, superior product quality, and brand cachet have allowed Snap-on to capture an estimated 50% of the professional tool market.

Pitney Bowes PBI
Market cap: $5.2 billion
Moat: Narrow
Fair value estimate: $38
Uncertainty: Medium

Since Pitney Bowes began operations in 1920 as the first postage meter company, it has dominated the business. Today the company has an 80% share of the domestic postage meter market and a 65% share internationally. Because postage meters essentially print currency, they are highly regulated by the governments of their respective countries. This is a huge barrier to entry and allows Pitney Bowes to operate with little competition. It has also allowed the company to develop deep relationships with governments and customers that perpetuate its competitive advantage and enhance its brand recognition.

Haywood Kelly, CFA, is vice president of equity research at Morningstar.

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